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Sovereign Market Dislocation and Derivatives Turmoil

Seven UK mutual funds thus far have halted withdrawals and/or taken significant write-downs on fund asset values. Combined fund assets are about 20 billion pounds. Back in June 2007, it was the implosion of funds managed by Bear Stearns with about $20 billion of assets that set in motion the collapse of the mortgage finance Bubble. To be sure, bursting Bubble dislocations would have been less destructive had "Terminal Phase" excess not run roughshod throughout 2007 and well into 2008.

When I criticized the Fed's reflationary policies back in 2009 - and initially warned of the emergence of the "global government finance Bubble" - the focus of my concerns was not hyperinflation or a dollar collapse. My worry was the likelihood for massive global fiscal and monetary stimulus to foster a systemic mispricing of "finance" - securities prices and Credit more generally. From this global macro perspective, the outcome has been my worst-case-scenario. Actually, policy measures and attendant pricing distortions have been far more extreme than I could have imagined.

Japanese 10-year JGB yields ended the week at negative 0.29%. German 10-year bund yields closed the week at a record low negative 0.19%, and Swiss yields were a record low negative 0.69%. French 10-year yields ended Friday's session at an all-time low 10 bps. The Netherlands saw yields drop to zero. U.K. gilt yields sank 10 bps to a record low 0.73%. And despite stronger-than-expected job gains, Treasury yields closed the week at a record low 1.36%.

Italy, with three Trillion of sovereign debt measured at a problematic 135% of GDP (and growing), ended the week with 10-year yields at a record low 1.19%. Mario Draghi's "whatever it takes" has had a most profound impact on Italian yields (down about 500bps since the summer of 2012). Yet despite collapsing borrowing costs, Italy nonetheless runs persistent budget deficits. And while the ECB has thus far succeeded in keeping Italy solvent, the same cannot necessarily be said for Italy's troubled banking industry (see "Italy Watch" below).

From the Wall Street Journal (Giovanni Legorano): "In Italy, 17% of banks' loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans."

In a more normal market backdrop, Italy's finances would today be in crisis. Surging sovereign yields and failing banks would have forced harsh but needed financial, fiscal and economic structural reform. This should have transpired years ago. These days there is perhaps some tension, but there's no burning crisis in Rome. Prime Minister Renzi, while politically weakened at home, can use his government's vulnerability to wield impressive power in Brussels and Frankfurt, especially post Brexit. After all, Italy could rather easily bring down the European banking system. Indeed, the Italians today hold sway over the euro currency, and Renzi knows he's playing a strong hand.

July 6 - Reuters (Isla Binnie): "The difficulties facing Italian banks over their bad loans are miniscule by comparison with the problems some European banks face over their derivatives, Italian Prime Minister Matteo Renzi said... Speaking at a joint news conference with Swedish Prime Minister Stefan Lofven, Renzi said other European banks had much bigger problems than their Italian counterparts. 'If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred,' Renzi said."

On the back of talk of EU concessions (further flouting of rules) on bank bailouts, Italian banks rallied 9.7% Friday (w-o-w plus 2%, y-t-d down 53%). Despite Friday's 3% rally, Germany's behemoth Deutsche Bank ended the week down another 4.4%. Deutsche Bank has now lost almost half its value this year. And I'll assume Renzi had his mind on DB and a few other major German and French banks with his claim that derivative issues are 100 times larger than Italian loan troubles. Italy's problem loans pile is gargantuan, yet I reckon the Prime Minister could be onto something.

By this point, there's a prevailing numbness that has enveloped the markets. The extraordinary passes almost as the typical and familiar. One can only say "incredible" and "amazing" so many times - and for so long. The naysayers, well, they've been bloodied into submission. And while tired debates remain fixated on "bull vs bear", "expansion vs recession" and "inflation vs deflation", global markets are in the midst of a phenomenal development with momentous ramifications.

Global sovereign debt markets have wildly dislocated, with a concerted yield collapse unparalleled in history. At the same time, there are literally hundreds of Trillions of interest rate swaps, swaptions and myriad sophisticated derivatives and derivative trading strategies - comprising by far the largest market in the world. Hands down it's the murkiest. Still, extraordinary moves in yields, various spreads and yield curve structures ensure that there are enormous (and rapidly growing) embedded gains and losses lurking throughout the derivatives marketplace. Wonder where?

It's also worth noting that the Japanese yen, another heavy-weight in the derivatives universe, gained almost 2% this week, pushing y-t-d gains versus the dollar to 16.6%. Ominously, Japan's TOPIX Bank index was clobbered 6.4% this week, boosting 2016 losses to 41%.

Market dynamics may appear virtuous, but there's a strong case to be made for an especially vicious cycle. The labyrinth interest-rate derivatives complex operates with near-zero transparency. But we can posit some educated top-down assumptions: As we've witnessed repeatedly, especially since 2012, heightened systemic risk spurs more QE. This additional QE fosters "front-running" speculative buying in sovereign debt markets (cash and derivatives) backstopped by aggressive central banks.

QE, meanwhile, completely fails to contain expanding systemic risk. "Whatever it takes" instead exacerbates market speculation, volatility and uncertainty. And having painted themselves into a corner, central banks effectively cling to one weapon to counteract instability: More QE. So it reaches the point - the point we're at today - where acute fragility incites a vicious combination of more QE, short covering, speculative front-running and safe haven buying. There's simply a rapidly expanding quantity of "money" chasing a hastily declining supply of bonds.

Prospects for aggressive rate cuts (and perhaps even "helicopter money") from the Bernanke Fed were instrumental in fueling a spectacular energy market speculative blow-off right into the 2008 crisis. Commodities surged generally, with WTI hitting its $145 all-time high in July 2008. Treasury bond prices made a similar parabolic move, while the huge rally in GSE debt and MBS was instrumental in extending "Terminal Phase" mortgage excesses. Importantly, the risk markets turned tightly correlated. It all became one precarious liquidity-induced speculative Bubble poised to burst.

World markets are in the midst of something on a frighteningly grander scale than 2007-2008. Tens of Trillions of sovereign debt have become trapped in speculative melt-up dynamics, as central bankers, derivative traders, speculators and safe haven buyers all battle to procure precious bonds. And I don't believe it's coincidence that the world's largest derivative players are seeing their stock prices suffer under intense selling pressure. Meanwhile, sinking bank shares heighten market fears, which only feeds the dislocation and reinforces the dynamic imperiling the big derivative operators.

Brexit hit as market dislocation had already attained powerful momentum. A crisis of confidence then engulfed the UK lenders. Moreover, major Brexit-related uncertainties weakened already waning confidence in Italian banks, and European banking (and currencies) more generally. European worries exacerbated Asian worries. And the worse things look for Italian and European banks the more convinced the markets become of additional concerted "whatever it takes" - in Europe, the UK, Japan and elsewhere including even the U.S.

I guess it might have gone either way. Brexit could easily have spurred a problematic "risk off." Instead, a globally super-charged sovereign debt dislocation/melt-up has completely overwhelmed the markets. The disappearing supply of sovereigns and resulting evaporation of yields - coupled with the prospect of endless QE - have led to a generalized risk market short-squeeze and unwind of hedges. This worked to solidify the notion that corporates and EM would now provide the primary source of yield for a freakishly yield-desperate world. And with visions of over-abundant liquidity and ultra-low corporate borrowing costs as far as the eye can see - replete with M&A boom and buybacks forever - it has become possible to overlook a lengthening list of fundamental factors overhanging equities markets.

A couple of notable Friday (WSJ) headlines: "Market Extra: S&P 500 near record highs? Treasury Yields at Lows? Something's Gotta Give" and "Sovereigns Face Record Year for Downgrades." In the face of mounting risk, "money" now floods into the risk markets. Curiously, at least for the week, economically-sensitive commodities, including energy (crude down 7.9%) and copper (down 4.6%), were hammered, especially in comparison to the precious metals.

July 6 - Bloomberg (Taylor Hall and Charles Stein): "It's another record for Vanguard Group Inc. The firm, which has grown to become the world's largest mutual fund manager by offering low-cost investments, attracted $148 billion in new client money during the first six months of 2016, surpassing its previous first-half record of $140 billion set last year... In June alone, about $30 billion flooded into the firm's mutual funds and exchange-traded products."

The Flood goes way beyond equities index products. I suspect flows into perceived low-risk dividend and yield plays have gone from enormous to more enormous. After having been on the receiving end of robust flows for some time, it appears Brexit actually incited greater inflows into corporate debt.

July 7 - Bloomberg (Joe Rennison): "Investors poured money into corporate bond funds over the past week, as demand for fixed rate returns accelerated against the backdrop of global government debt yields hitting record lows. Bond funds had inflows of $14.4bn, with the US receiving the lion's share of $7.8bn."

The Fed's 2007 reflationary policies spurred strong flows into the risk markets - in the face of a horrible risk vs reward calculus. Washington had seemingly transformed the entire mortgage finance complex into a low-risk proposition: "The Moneyness of Credit." When confidence inevitably waned there was an uncomfortably sudden appreciation that safety and liquidity had become major issues. The halting of redemptions in Bear Stearns' mutual fund shares was a major inflection point. Confidence was shaken. It was the beginning of the end. It was, as well, the kickoff for a bout of destabilizing wild and crazy.

Throughout history real estate has provided a convenient bastion for financial innovation and speculation. Why not let retail investors in on the strong returns available in booming London and UK real estate markets, especially with decent yields unavailable elsewhere. Why not transform inflating illiquid assets into perceived safe and liquid shares for the masses - especially with central banks destroying yields for tens of Trillions of debt securities?

The "Moneyness of Risk Assets" has been a centerpiece of my global government finance Bubble analysis. It was an epic misconception to print "money" by the Trillions, incentivize massive flows (and speculative leverage) into risk markets in order to reflate the U.S. and the world - and then respond to inevitable instability with "whatever it takes" activism and further market manipulation. The Fed and global central bankers have nurtured the illusion that risk markets are safe and liquid (money-like). They have spurred "contemporary finance" and the transformation of increasingly risky assets into perceived safe and liquid securities. Ironically, as the liquidity myth is illuminated in UK real estate funds, a sovereign debt market dislocation ensures "money" floods into potential liquidity traps in risk markets around the world.


For the Week:

The S&P500 gained 1.3% (up 4.2% y-t-d), and the Dow increased 1.1% (up 4.1%). The Utilities added 0.2% (up 21.7%). The Banks increased 0.4% (down 11.8%), and the Broker/Dealers gained 2.1% (down 14.2%). The Transports advanced 1.7% (up 2.3%). The S&P 400 Midcaps rose 1.3% (up 8.7%), and the small cap Russell 2000 gained 1.8% (up 3.7%). The Nasdaq100 advanced 2.0% (down 1.4%), and the Morgan Stanley High Tech index rose 2.1% (down 0.1%). The Semiconductors jumped 2.3% (up 5.7%). The Biotechs gained 2.2% (down 17%). With bullion rising $25, the HUI gold index jumped 4.8% (up 144.2%).

Three-month Treasury bill rates ended the week at 27 bps. Two-year government yields added two bps to 0.61% (down 44bps y-t-d). Five-year T-note yields declined four bps to a multi-year low 0.95% (down 80bps). Ten-year Treasury yields fell eight bps to a record low 1.36% (down 89bps). Long bond yields dropped 13 bps to a record low 2.10% (down 92bps).

Greek 10-year yields rose eight bps to 7.76% (up 44bps y-t-d). Ten-year Portuguese yields gained seven bps to 3.05% (up 53bps). Italian 10-year yields declined four bps to 1.19% (down 40bps). Spain's 10-year yields were unchanged at 1.14% (down 63bps). German bund yields fell six bps to negative 0.19% (down 81bps). French yields declined five bps to 0.10% (down 89bps). The French to German 10-year bond spread widened a basis point to 29 bps. U.K. 10-year gilt yields dropped 10 bps to a record low 0.73% (down 123bps).

Japan's Nikkei equities index sank 3.7% (down 20.6% y-t-d). Japanese 10-year "JGB" yields declined two bps to a record low negative 0.29% (down 55bps y-t-d). The German DAX equities index fell 1.5% (down 10.4%). Spain's IBEX 35 equities index declined 1.0% (down 14.2%). Italy's FTSE MIB index dropped 1.4% (down 25%). EM equities were mixed. Brazil's Bovespa index gained 1.7% (up 22.6%). Mexico's Bolsa declined 1.0% (up 6.4%). South Korea's Kospi index declined 1.2% (up 0.1%). India's Sensex equities index was little changed (up 3.9%). China's Shanghai Exchange rose 1.9% (down 15.6%). Turkey's Borsa Istanbul National 100 index was about unchanged (up 8.8%). Russia's MICEX equities Index was little changed (up 7.6%).

Freddie Mac 30-year fixed mortgage rates dropped seven bps to 3.41% (down 63bps y-o-y). Fifteen-year rates fell four bps to 2.74% (down 46bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down three bps to 3.64% (down 50bps).

Federal Reserve Credit last week declined $6.3bn to $4.428 TN. Over the past year, Fed Credit fell $12.4bn. Fed Credit inflated $1.619 TN, or 58%, over the past 191 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $4.5bn last week to $3.230 TN. "Custody holdings" were down $138bn y-o-y, or 4.1%.

M2 (narrow) "money" supply last week jumped another $31.7bn to a record $12.849 TN. "Narrow money" expanded $824bn, or 6.9%, over the past year. For the week, Currency increased $2.5bn. Total Checkable Deposits fell $28.6bn, while Savings Deposits surged $61bn. Small Time Deposits were little changed. Retail Money Funds declined $3.9bn.

Total money market fund assets declined $17.4bn to $2.701 TN. Money Funds rose $67bn y-o-y (2.5%).

Total Commercial Paper fell $11.1bn to $1.040 TN. CP expanded $19bn y-o-y, or 1.0%.

Currency Watch:

July 7 - Reuters: "China' foreign exchange reserves in June unexpectedly rose $20 billion to $3.21 trillion..., rebounding from a 5-year low in May. Foreign exchanges reserves stood at $3.21 trillion at the end of June... China's reserves, the largest in the world, fell by $27.9 billion to $3.19 trillion in May..."

The U.S. dollar index gained 0.7 to 96.28 (down 2.4% y-t-d). For the week on the upside, the Japanese yen increased 1.9%, the New Zealand dollar 1.8%, the Australian dollar 0.9% and the South African rand 0.2%. For the week on the downside, the British pound declined 2.4%, the Norwegian krone 2.2%, the Brazilian real 2.0%, the Swedish krona 1.7%, the Canadian dollar 1.0%, the Swiss franc 1.0%, the Mexican peso 0.8% and the euro 0.8%. The Chinese yuan declined another 0.5% versus the dollar, increasing 2016 losses to 3.0%.

Commodities Watch:

The Goldman Sachs Commodities Index sank 4.9% (up 14.9% y-t-d). Spot Gold gained another 1.9% to $1,366 (up 29%). Silver jumped 2.5% to $20.35 (up 48%). WTI Crude dropped $3.87 to $45.41 (up 23%). Gasoline slid 9.9% (up 8%), and Natural Gas dropped 5.7% (up 21%). Copper lost 4.6% (down 1%). Wheat gained 1.1% (down 7.4%). Corn declined 1.4% (down 1%).

Europe Watch:

July 4 - Financial Times (Tony Barber): "Europe's faultline runs through Italy. Such was the candid opinion of one participant in a conference held last weekend by Eliamep, an Athens-based think-tank. Few other participants dissented. By 'Europe' everyone understood, primarily, the 19-nation eurozone. For the question on the minds of European policymakers is where, and to what extent, political, financial and economic contagion may spread from Britain's June 23 vote to leave the EU. The sharp falls in Italian banks' share prices since the British referendum indicate where financial markets smell the danger of contagion. But Italy is the focus of attention not only because of its undercapitalised banks, colossal public debt and miserable economic growth."

July 6 - Bloomberg (Ross Larsen, Guy Johnson and Caroline Hyde): "Italy's banking crisis could spread to the rest of Europe, and rules limiting state aid to lenders should be reconsidered to prevent greater upheaval, Societe Generale SA Chairman Lorenzo Bini Smaghi said. 'The whole banking market is under pressure,' the former European Central Bank executive board member said... 'We adopted rules on public money; these rules must be assessed in a market that has a potential crisis to decide whether some suspension needs to be applied.' With about 360 billion euros ($389bn) in soured loans saddling Italian banks, the government has sounding out regulators on ways to shore up lenders bruised by a renewed selloff after the British vote to leave the European Union. The government would invoke an EU rule allowing temporary state aid if regulatory stress tests uncover a shortfall at Banca Monte dei Paschi di Siena SpA, a person with knowledge of the discussions said..."

July 4 - Wall Street Journal (Robert Wall): "There is no Plan B. That is what many companies across Europe have been telling investors since Britain voted to leave the European Union. The exit and its timing are so uncertain, executives say, that few companies had any meaningful contingency plans to either defend against the fallout or take advantage of the opportunity. 'I can't even assess the impacts this could have on us in operational terms,' says Maurizio Focchi, chief executive of Focchi... Almost 70% of German firms surveyed by the Federation of German Industries, or BDI, ahead of the vote said they didn't know how they would react to a Brexit vote."

July 7 - Reuters (Michael Holden): "British consumer confidence fell at the fastest pace in 22 years after last month's decision by voters to leave the European Union, according to a survey by... GfK cited by the Daily Telegraph... The survey said consumer morale fell to -9 in the aftermath of the June 23 vote down from -1 in its previous monthly survey, representing the biggest drop in confidence since December 1994."

July 4 - Wall Street Journal (Giovanni Legorano): "Britain's vote to leave the EU has produced dire predictions for the U.K. economy. The damage to the rest of Europe could be more immediate and potentially more serious. Nowhere is the risk concentrated more heavily than in the Italian banking sector. In Italy, 17% of banks' loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans. Years of lax lending standards left Italian banks ill-prepared when an economic slump sent bankruptcies soaring a few years ago. At one major bank, Banca Monte dei Paschi di Siena SpA, bad loans were so thick it assigned a team of 700 to deal with them and created a new unit to house them."

July 4 - Bloomberg (Lucy Meakin): "Confidence of British executives plunged and pessimism doubled as the Brexit turmoil stoked concerns that business investment and the property market are poised to slump. An index published by YouGov Plc and the Centre for Economics and Business Research on Tuesday tumbled to 105 from 112.6 in the three days ended June 23, the referendum date. The survey... also found the proportion of businesses that are pessimistic about the economic outlook climbed to 49% from 25%. 'These figures show what is happening on the ground and they suggest a significant shock reaction,' said the institute's director, Scott Corfe. 'Not only are businesses feeling much more pessimistic in general about the state of the economy, but their own expectations for domestic sales, exports and investments over the next 12 months have gone off a cliff.'"

July 6 - Financial Times (Nathalie Thomas): "A steep decline in retail sales in Italy - a nation normally renown for its love of shopping and fashion - has pushed the eurozone's retail sector back into contraction territory, according to a survey of activity. Markit's purchasing managers' index for Italy's retail sector slumped to a 31-month low for June, dragging an index covering the euro area as a whole to a two-month low and back into negative territory. The eurozone retail PMI came in at 48.5 for June, down from 50.6 in May."

Brexit Watch:

July 7 - Bloomberg (Chris Vellacott): "The U.K.'s credit-rating cut after voting to leave the European Union may be the first in a run of sovereign downgrades in the bloc if fiscal prudence takes a back seat to tackling political instability across the continent, Fitch Ratings said... When Fitch cut Britain's rating to AA from AA+ in June, the country became one of 15 sovereign debtors demoted in the first half. With 22 nations from Japan to Angola carrying a negative outlook, it's 'likely' the total number of cuts this year will exceed the record 20 downgrades in 2011..."

July 7 - Wall Street Journal (Stephen Wilmot): "A post-Brexit shutdown in the U.K. commercial-property market flared into the open this week. Mutual funds invested in offices and shops, which normally offer daily liquidity, closed their doors. But the real risk isn't in commercial but residential real estate. If the small investors that have bought flats to let out also decide that the U.K. property gold rush is over, things really would get messy. Six funds have now halted withdrawals, sometimes following abrupt valuation movements... The real nightmare scenario would be a parallel wave of investor selling in the residential market. So-called buy-to-let loans have been a major growth sector for U.K. banks, as investors have used cheap debt to chase house-price growth."

July 6 - Bloomberg (Alastair Marsh): "Investors in U.K. commercial real estate just touched a nerve. In pulling their money out of property funds at such a rapid pace four asset managers froze withdrawals this week, the investors showed how the cost of Brexit is spreading. They also tapped into one of the biggest fears of bond market observers: a mismatch between the liquidity of investment funds and their assets. The real estate funds are designed to allow investors to withdraw their money on a daily basis, while the properties backing them could take months to sell. That's similar to many mutual and exchange-traded funds that buy junk bonds -- securities that can take weeks to sell -- and offer daily redemptions. Yet while the property funds have grabbed the headlines and spooked markets, the bigger threat may be posed by bond funds. Only about 7% of the total commercial real estate market is held in daily-dealing funds, according to the Bank of England. Meanwhile more than 90% of all European corporate debt funds, including high-yield bonds, offer daily redemptions, according to Fitch Ratings."

July 6 - Bloomberg (Saijel Kishan): "Aberdeen Fund Managers Ltd. said it will make a 'dilution adjustment' to the Aberdeen UK Property Fund and the Aberdeen UK Property Feeder Unit Trust after Britain's vote to leave the European Union hit commercial real estate values. The adjustment will lead to a 17% decline in the funds' dealing price..."

July 7 - Bloomberg (Alastair Marsh): "M&G Investments and Standard Life Investments just got a taste of their own medicine, and it's bitter. The two firms -- large asset managers in London and Edinburgh -- were among seven that this week froze withdrawals from real estate funds with about 18 billion pounds ($23.5bn) of assets as investors sought to dump property investments following Britain's vote to leave the European Union. It turns out they're also investors in some of the gated funds... Dig into who's invested in the frozen property funds and you'll find the usual real money accounts, from HSBC Global Asset Management to Baring Asset Management Ltd., that have been boosting exposures to real assets as bond yields and interest rates trend lower. You'll also see M&G owns more than 2 million shares in Aviva's suspended fund, while Standard Life holds about 2.4 million shares in M&G's fund..."

Italy Watch:

July 5 - Reuters (Crispian Balmer): "Italy's bank shares plunged on Tuesday, shaking the financial foundations of the euro zone's third-largest economy and threatening contagion to other EU nations. The crisis could push Italy back into recession and, in a doomsday scenario, generate a Greece-type meltdown that Europe would find almost impossible to contain Italy's banks are suffocating under a pile of non-performing loans and, adding to the growing sense of instability, Prime Minister Matteo Renzi has promised to resign if he loses a referendum in October on constitutional reform. Recent opinion polls say he will fall well short. 'Italy faces a severe crisis that is exponential. This is not gradual and not linear,' said Francesco Galietti, head of the Policy Sonar risk consultancy and a former finance ministry official. 'The immediate trigger is the banking crisis.' Italy's bank sector index has fallen 30% since Britain voted on June 23 to quit the European Union, bringing its losses so far this year to 57%. The euro zone banking stocks index has dropped 22% and 37% respectively."

July 3 - Financial Times (Rachel Sanderson and Alex Barker): "Italy is prepared to defy the EU and unilaterally pump billions of euros into its troubled banking system if it comes under severe systemic distress, a last-resort move that would smash through the bloc's nascent regime for handling ailing banks. Matteo Renzi, the Italian prime minister, is determined to intervene with public funds if necessary despite warnings from Brussels and Berlin over the need to respect rules that make creditors rather than taxpayers fund bank rescues... The threat has raised alarm among Europe's regulators, who fear such a brazen intervention would devastate the credibility of the union's newly implemented banking rule book during its first real test."

July 5 - Bloomberg (Sonia Sirletti, John Follain and Chiara Albanese): "Italy is looking to pump capital into Banca Monte dei Paschi di Siena SpA in what may become the lender's third bailout since the financial crisis, a person with knowledge of the plan said. The government would invoke a European Union rule allowing temporary state aid if regulatory stress tests uncover a shortfall, said the person, asking to not be identified because the plan isn't public. Talks are underway with European regulators to win approval, the person said. An Italian bank rescue would evoke the taxpayer bailouts of the financial crisis as well as test the bailout rules, which took full effect this year, forcing bondholders and shareholders to share losses."

July 4 - Financial Times (Rachel Sanderson): "The world's oldest bank, which has been cleaned up twice by Italian authorities, has been told by the European Central Bank it needs to shed another €10bn in bad loans, sparking fresh worries over the health of the troubled Italian banking sector. Shares in Monte dei Paschi di Siena, founded in 1472 and Italy's third-largest lender, dropped 13% on Monday to an all-time low after it disclosed the ECB warning, dragging down all of the country's largest lenders. UniCredit, Italy's only globally systemic bank, was down 3.8% and also hit an all-time low. The FTSE Italia All-Share Banks index was down 3.7%. It has lost nearly 56% of its value this year."

July 6 - Financial Times (James Politi): "The populist Five Star Movement has emerged as Italy's leading political party, overtaking Matteo Renzi's ruling Democratic party (PD) in four separate opinion polls that have exposed the growing vulnerability of the country's centre-left prime minister. The primacy of the Five Star Movement... reflects a shift in public opinion against Mr Renzi that will heighten fears of a return to political instability and uncertainty in the single currency's third largest economy. It could add to existing investors' concerns about the Italian banking system... It will also raise alarm bells about the fate of an autumn referendum on constitutional reform on which Mr Renzi has staked his political career."

Central Bank Watch:

July 4 - Bloomberg (Piotr Skolimowski): "The European Central Bank bought 85.1 billion euros ($94.8bn) of debt in June as it boosted its asset-purchase program before the summer holiday period, and as officials considered how to handle the fallout from the U.K.'s decision to quit the European Union."

Fixed-Income Bubble Watch:

July 6 - Wall Street Journal (Min Zeng and Christopher Whittall): "Christopher Sullivan, a money manager in New York, is worried that when he needs U.S. Treasury bonds one day, he might not be able to get them. On the surface, the concern might seem unwarranted: The U.S. Treasury has $13.4 trillion in debt securities outstanding, making the U.S. bond market the largest in the world and Treasurys among the most easily traded asset classes... A buying spree by central banks is reducing the availability of government debt for other buyers and intensifying the bidding wars that break out when investors get jittery, driving prices higher and yields lower. The yield on the benchmark 10-year Treasury note hit a record low Wednesday. 'The scarcity factor is there but it really becomes palpable during periods of stress when yields immediately collapse... You may be shut out of the bond market just when you need it the most.'"

Global Bubble Watch:

July 4 - Bloomberg (Tracy Alloway): "There's a big disagreement brewing in global markets. While risky assets including equities have surged following the U.K. electorate's historic vote to leave the European Union, government bonds have also rallied; two things that ought to suggest different outlooks for economic growth. Soaring bond prices have sent yields on the perceived safe havens of government debt plumbing fresh lows, even while expectations of looser monetary policy produce a burst of animal spirits in stock markets. The flight to safety has prompted some analysts to question the durability of the rally in equities, where the S&P 500 was up 3.5% last week and the FTSE 100 has erased its post-referendum dip... Still others say that money is pouring into stocks as lower bond yields force investors to search for returns in alternative asset classes."

July 6 - Wall Street Journal (David Reilly): "Big banks are nearly half a trillion dollars in the hole. Since the start of 2016, 20 of the world's bigger banks have lost a quarter of their combined market value. Added up, it equals about $465 billion... Brexit isn't all to blame. True, bank stocks have plummeted since the U.K. voted last month to leave the European Union. But they have been losing value since the start of the year, when a group of factors--the Chinese economy, the path of U.S. interest rates, oil prices--weighed on the markets. More than pride is at stake. Sharp share-price falls will make it much more difficult, and expensive, for banks to raise capital if that is what is ultimately needed to shore up their balance sheets."

July 4 - Reuters (Anjuli Davies): "Global investment banking fees fell by nearly a quarter in the first half of 2016 from a year earlier as market volatility hit capital markets and M&A deal making, Thomson Reuters data... showed. Global fees for services ranging from merger and acquisitions advisory services to capital markets underwriting fell 23% to $37.1 billion at the end of June, the slowest first half for fees since 2012. While 2015 was a record year for M&A, 2016 is shaping up to be a record year for 'broken' deals..."

July 6 - Bloomberg (Jonathan Browning): "Chinese companies have gone big game hunting this year. Yet that record run is threatened by a rising set of challenges -- not to mention the Brexit shock. It took less than six months for the volume of announced Chinese outbound deals to surpass last year's total of $120 billion -- itself a milestone. But now, Chinese buyers are facing tougher regulatory opposition abroad, while at home they must grapple with a government keen to stabilize a yuan pressured by outflows from $148 billion of overseas deals this year. 'Chinese outbound M&A is likely to slow down in the second half of the year,' said Zilong Wang, head of mergers and acquisitions at China International Capital Corp... 'Mainland companies may face greater scrutiny in transferring funds offshore for acquisitions.'"

July 4 - Bloomberg (Josh Wingrove): "Canadian sentiment had its biggest drop in a year after the Brexit decision, with confidence in the domestic economy, housing prices and job security all falling."

U.S. Bubble Watch:

July 4 - Financial Times (Adam Samson): "US companies face another bleak earnings season with analysts forecasting the longest profit recession since the financial crisis. Energy groups are expected to weigh heavily on S&P 500 results while a number of other sectors such as financials are struggling to increase profitability. Earnings of the major groups that comprise the S&P 500 index are seen falling 5% in the second quarter from the same three-month period in 2015. That forecast is slightly lower than the 6.8% decline seen during the first quarter, but will mark the fourth-straight quarterly decline, according to... S&P Global Market Intelligence... The S&P 500 closed out the first half priced at 19.5 times trailing 12-month earnings, one of the highest multiples since 2004..."

July 4 - Wall Street Journal (Serena Ng): "America's shadow banking system slowed sharply through the end of June, with the value of bonds backed by personal, corporate and real-estate loans falling $98 billion from the first half of 2015. That drop, which excludes bonds from state-backed issuers like Fannie Mae, represents a 37% decline from a year earlier, according to... Asset-Backed Alert, and is making it harder for businesses, shopping-mall owners and consumers to refinance their debt. The pullback was triggered by the investor flight from riskier types of bonds around the New Year and persisted even as broader market conditions improved."

July 6 - Bloomberg (Sho Chandra): "The U.S. trade deficit widened in May by the most in nearly a year as exports fell and a pickup in domestic demand led to more imports of consumer goods and industrial materials. The gap grew by 10.1%, the most since August 2015, to $41.1 billion from the prior month..."

China Bubble Watch:

July 3 - Bloomberg: "Predictions of a Chinese banking system bailout are going mainstream. What was once the fringe view of permabears and short sellers is now increasingly being adopted by economists at some of the world's biggest banks and brokerages. Nine of 15 respondents in a Bloomberg survey..., including Standard Chartered Plc and Commonwealth Bank of Australia, predicted a government-funded recapitalization will take place within two years. Among those who provided estimates of the cost, a majority said it will exceed $500 billion."

July 7 - Reuters: "Outstanding non-performing loans (NPLs) in China's vast banking sector exceeded the two trillion yuan ($299.21bn) mark at the end of May, a senior banking regulator official said... Chinese banks' NPL ratio climbed to 2.15% of total bank lending at the end of May, up 0.16 percentage point from the beginning of 2016, Yu Xuejun told a conference... NPLs grew more than 280 billion yuan in the first five months of this year, he added... Non-performing loans at Chinese commercial banks alone rose to an 11-year-high of 1.4 trillion yuan, or 1.75% of total bank lending at end-March."

July 6 - Wall Street Journal (Anjani Trivedi): "Life insurance is supposed to be a bet you can't win. Not in China. Big bets and high stakes are how China's rising breed of unlisted life insurers have taken on the business. Despite a failed, high-profile bid to buy up U.S. hotel chain Starwood Hotels & Resorts, Anbang Group's unlisted life-insurance arm is now China's second largest insurer by premiums, overtaking industry giant Ping An... Through its explosive 463% premium income growth, Anbang's market share has gone from 0.7% in 2013 to almost 10% this year. Two other unlisted insurers, Huaxia and Sinolife, have grown rapidly as well. The likes of Anbang Life have thrived even as insurers globally struggle with falling interest rates. Profits, unlike at listed peers, are largely a function of illiquid-asset investments made using the main insurance business as a financing vehicle."

July 7 - Bloomberg: "Chinese President Xi Jinping is putting more of the 'state' in 'state-owned enterprise.' Carmaker FAW Car Co., fiber producer Sinoma Science & Technology Co. and miner Tibet Mineral Development Co. have recently modified their bylaws to give Xi's Communist Party more oversight of management decisions. For example, company boards will now have an obligation to listen to internal party committees before making major decisions. 'Communist Party officials are stepping up intervention in day-to-day operations of state-owned corporations,' said Xu Baoli, a senior researcher with the State-owned Assets Supervision and Administration Commission... 'There were cases in the past where the board would reject a proposal that had gone through the party. I doubt whether that will happen in the future.'"

July 3 - Financial Times (Yuan Yang and Tom Mitchell): "China's private sector has missed out on the country's credit boom over the past eight years, a new study has shown, despite Beijing's efforts to rebalance the economy away from state-dominated heavy industry. Private sector debt has fallen from 48% of total assets in 2008 to 35% in 2015, according to economists at Beijing University. Over the same period, state sector debt rose slightly to 53%... 'Good leverage is decreasing as bad leverage increases,' said Huang Yiping at Beijing University's National School of Development... Liu Yonghao, a self-made agribusiness tycoon and co-founder of Minsheng Bank, told the Financial Times that the 'banking sector isn't fit for the age we live in'. 'Our banks and financial institutions serve the state-owned sector and the government,' Mr Lui said..."

July 7 - Reuters (Sue-Lin Wong): "The Chinese government's call to the nation to build an innovation-driven economy from the top down has sparked a rush by local governments to construct new buildings in the name of supporting creativity. Innovation centers have been popping up around the country and are set to more than double to nearly 5,000 in the next five years, according to internet research firm iiMedia. The only problem for local governments; entrepreneurs are not moving in. Many centers are in small Chinese cities or towns, not ideal locations for attracting startups. There is no local market for their product, no local ecosystem of suppliers and fellow entrepreneurs and centers generally provide only basic amenities... They lack the financial, technical or marketing expertise that many startups need. Most incubators have occupancy rates of no more than 40%, iiMedia says. The result: like steel mills, theme parks and housing before them, the country now faces a glut of innovation centers as another top-down policy backfires to leave white-elephant projects and a further buildup of debt."

July 4 - CNBC (Leslie Shaffer): "China has suffered from outflows from its foreign reserves for months. Goldman Sachs and Standard & Poor's can't agree why... China's foreign exchange reserves fell to $3.19 trillion in May, the lowest since December 2011, down $27.9 billion from the previous month and the largest monthly drop since February... China saw a total drop in reserves of around $513 billion in 2015, with $420 billion of that in the last six months of the year... Goldman Sachs estimated that net capital outflows from China in the first quarter of 2016 were around $123 billion, compared with around $504 billion in the second half of last year. It believed that around 70% of the net outflows were due to Chinese residents buying foreign assets and 40% due to repayment of foreign-exchange liabilities."

Japan Watch:

July 5 - Reuters (Stanley White): "Activity in Japan's services sector contracted in June as new business shrank the fastest in almost five years, adding to worries that the economy is losing momentum due to weak consumer spending, a private business survey showed... The Markit/Nikkei Japan Services Purchasing Managers Index (PMI) fell to 49.4 in June from 50.4 in May..."

Leveraged Speculator Watch:

July 6 - Financial Times (Alistair Gray and Miles Johnson): "Recent losses suffered by hedge funds have called into question the business model of the offshore-based reinsurers that provide capital used by them to invest, according to Standard & Poor's... So-called hedge fund reinsurers have failed to make a profit from providing reinsurance cover for more than four years... Investment income -- the other main way in which reinsurers make money -- plummeted almost two-thirds last year, it found. Some of the world's biggest hedge fund managers... have affiliated offshore entities that offer reinsurance that helps fund the costs of earthquakes, hurricanes and other disasters. But S&P questions whether all HFRs will survive, describing some as at risk of being left as 'carcases on the side of the road' as difficulties in the reinsurance sector conspire with poor hedge fund performance."

Geopolitical Watch:

July 6 - New York Times (Jane Perlez): "Five judges and legal scholars from around the world presided over a hearing last fall in an elegant, chandeliered room in The Hague. Arranged before them on one side of the chamber were lawyers for the Philippines... On the other side were three empty chairs. For more than three years, China has refused to participate in the proceedings of an international tribunal considering a challenge to its expansive claims in the South China Sea, arguing that the panel has no jurisdiction to rule on the dispute with the Philippines. But with a decision scheduled to be announced next week, Beijing seems to be getting nervous. In a show of strength, it kicked off a week of naval exercises in the South China Sea on Tuesday near the disputed Paracel Islands, where the Chinese military has installed surface-to-air missiles."

July 4 - Reuters (Ben Blanchard and Megha Rajagopalan): "China's government sought to downplay fears of conflict in the South China Sea after an influential state-run newspaper said... that Beijing should prepare for military confrontation. Editorials in the Global Times newspaper ahead of a July 12 international court ruling on competing claims in the South China Sea by China and the Philippines said the dispute had already been complicated by U.S. intervention. It faced further escalation due to the threat posed by The Hague-based tribunal to China's sovereignty, the paper said. 'Washington has deployed two carrier battle groups around the South China Sea, and it wants to send a signal by flexing its muscles: As the biggest powerhouse in the region, it awaits China's obedience,' the Global Times said."

July 5 - Reuters (Megha Rajagopalan): "China strongly criticized Japan over a scramble of military aircraft from the two countries on Monday amid a dispute over islands in the East China Sea. Two Japanese fighter jets took 'provocative actions' at a high speed near a pair of Chinese fighter jets that were carrying out patrols in the East China Sea on June 17, China's defense ministry said... The Japanese planes used fire-control radar to 'light up' the Chinese aircraft, the statement added."

July 2 - Reuters (Idrees Ali): "A Russian warship carried out aggressive and erratic maneuvers close to a U.S. Navy ship in the eastern Mediterranean Sea, the second such Cold War-style incident there in a matter of weeks, the U.S. military said... The U.S. European Command said the Russian frigate, Yaroslav Mudry, came unnecessarily close to the guided-missile cruiser USS San Jacinto on June 30 and maneuvered in its wake."


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