Yellen: Where No Man Has Gone Before

by Peter Schiff

Although Fed Chairwoman Janet Yellen said nothing new in her carefully manicured semi-annual testimony to Congress this summer, her performance there, taken within the context of a lengthy profile in the New Yorker (that came to press at around the same time), should confirm that she is very different from any of her predecessors in the job. Put simply, she is likely the most dovish and politically leftist Fed Chair in the Central Bank's history.

While her tenure thus far may feel like a seamless extension of the Greenspan/Bernanke era, investors should understand how much further Yellen is likely to push the stimulus envelope into unexplored territory. She does not seem to see the Fed's mission as primarily to maintain the value of the dollar, promote stable financial markets, or to fight inflation. Rather she sees it as a tool to promote progressive social policy and to essentially pick up where formal Federal social programs leave off.

Despite her good intentions, the Fed's blunt instrument policy tools of low interest rates and money supply expansion can do nothing to raise real incomes, lift people out of poverty, or create jobs. Instead these moves deter savings and capital investment, prevent the creation of high paying jobs, and increase the cost of living, especially for the poor (They are also giving rise to greater international financial tensions, which I explore more deeply in my recently released quarterly newsletter). On the "plus" side, these policies have created huge speculative profits on Wall Street. Unfortunately, Yellen does not seem to understand any of this. But she likely has a greater understanding of how the Fed's monetization of government debt (through Quantitative Easing) has prevented the government from having to raise taxes sharply or cut the programs she believes are so vital to economic health.

But as these policies have also been responsible for pushing up prices for basic necessities such as food, energy, and shelter, these "victories" come at a heavy cost. Recent data shows that consumers are paying more for the things they need and spending less on the things they want. But Yellen simply brushes off this evidence as temporary noise.

In her Congressional appearances, Yellen made clear that the end of the Fed's six-year experiment with zero percent interest rates is nowhere in sight. In fact, the event is less identifiable today than it was before she took office and before the economy supposedly improved to the point where such support would no longer be needed. The Bernanke Fed had given us some guidance in the form of a 6.5% unemployment rate that could be considered a milestone in the journey towards policy normalization. Later on these triggers became targets, which then became simply factors in a larger decision-making process. But Yellen has gone farther, disregarding all fixed thresholds and claiming that she will keep stimulating as long as she believes that there is "slack" in the economy (which she defines as any level of unemployment above the level of "full employment.") Where that mythical level may be is open for interpretation, which is likely why she prefers it.

The Fed's traditional "dual mandate" seeks to balance the need for job creation and price stability. But Yellen clearly sees jobs as her top priority. Any hope that she will put these priorities aside and move forcefully to fight inflation when it officially flares up should be abandoned.

These sentiments are brought into focus in the New Yorker piece, in which she unabashedly presents herself as a pure disciple of John Maynard Keynes and an opponent of Milton Friedman, Ronald Reagan, and Alan Greenspan, figures who are widely credited with having led the rightward movement of U.S. economic policy in the last three decades of the 20th Century. (Yellen refers to that era as "a dark period of economics.")

Perhaps the most telling passage in the eleven-page piece is an incident in the mid-1990s (related by Alan Blinder who was then a Fed governor along with Janet Yellen). The two were apparently successful in nudging then Fed Chairman Alan Greenspan into a more dovish position on monetary policy. When the shift was made, the two agreed "...we might have just saved 500,000 jobs." The belief that central bankers are empowered with the ability to talk jobs in and out of existence is a dangerous delusion. As her commitment to social justice and progressivism is a matter of record, there is ample reason to believe that extremist monetary policy will be in play at the Yellen Fed for the duration of her tenure.

For the present, other central bankers have helped by taking the sting out of the Fed's bad policy. On July 16 the Wall Street Journal reported that the Chinese government had gone on a torrid buying spree of U.S. Treasury debt, adding $107 billion through the first five months of 2014. This works out to an annualized pace of approximately $256 billion per year, or more than three times the 2013 pace (when the Chinese government bought "just" $81 billion for the entire calendar year). The new buying pushed Chinese holdings up to $1.27 trillion.

At the same time, Bloomberg reports that other emerging market central banks (not counting China) bought $49 billion in Treasuries in the 2nd Quarter of 2014, more than any quarter since 3rd Quarter of 2012. These purchases come on the heels of the mysterious $50 billion in purchases made by a shadowy entity operating out of Belgium in the early months of this year (see story).

So it's clear that while the Fed is tapering its QE purchases of Treasury bonds, other central banks have more than picked up the slack. Not only has this spared the U.S economy from a rise in long-term interest rates, which would likely prick the Fed-fueled twin bubbles in stocks and real estate, but it has also enabled the U.S. to export much of its inflation. As long as this continues, the illusion that Yellen can keep the floodgates open without unleashing high inflation will gain traction. She may feel that there is no risk to continue indefinitely.

But as the global economic status quo is facing a major crisis, there is reason to believe that we may be on the cusp of a major realignment of global priorities. Despite her good intentions, if Yellen and her dovish colleagues do not receive the kind of open-ended international support that we have enjoyed thus far in 2014, the full inflationary pain of her policies will fall heaviest on those residents of Main Street for whom she has expressed such deep concern.

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US Stocks Diverge From European Stocks and High Yield Bonds

by Pater Tenebrarum

A Test of Broken Trendlines from Below?

The divergence between US and European stock markets which we discussed in late August continues to persist. This happens in spite of the fact that major European markets have been somewhat stronger than US markets in recent weeks, no doubt due to further easing by the ECB – which was first anticipated, and then became reality. In fact, the measures announced by the ECB “exceeded expectations”.

Below is an updated version of the chart we showed previously. Germany’s DAX and France’s CAC-40 have rallied back to their previously broken trendlines and appear to be turning down from there. If they fail to exceed the recent interim peaks, their divergence with the SPX will so to speak have been “perfected”. Note though that we have seen similar short term divergences between these markets before (it happened e.g. in the summer of 2013), so it remains to be seen if they are meaningful this time.

Even though one cannot be certain yet whether it is an important signal, it is something we are keeping an eye on, especially as all these markets are far more stretched to the upside than they were previously. We have picked the DAX and CAC-40 on purpose, because they are the stock markets of the euro zone’s “core” countries. Moreover, the DAX has been Europe’s strongest market, the only one that has managed to reach new all time highs since the 2008 crisis. To be sure, the divergence is relatively small at this juncture, due to the recent strength in European stocks. Obviously though, no-one is going to ring a bell and shout “this time it means something”, even if it later turns out that it did. So it probably pays to be aware of these things in good time. If the divergences are going to be invalidated, it is in any case likely to happen soon, as it would require only very little by way of an additional advance.

Another reason why these divergences may actually be more meaningful this time around is that a very similar divergence between SPX and HYG (an ETF serving as a proxy for high yield debt) has recently formed.

DAX, CAC-40 and SPX – the former are still diverging from the latter and may just have put in a lower high right at their previous trendline support – click to enlarge.

Similar to the divergence above, the one between SPX and HYG is also fairly small as of yet and may still be eradicated, but for the moment it clearly exists. After performing roughly in line with the stock market from 2009 to 2013, HYG has actually begun to weaken relative to the SPX since Q2 2013, a trend that has so far continued in 2014.

HYG and SPX also diverge at the most recent peak in US stocks – click to enlarge.

As the next chart shows, from 2009-2013, HYG and SPX rallied at roughly the same pace. This behavior has changed since Q2 2013, with the S&P 500 outperforming HYG in terms of capital gains. This shows that the decline in yields has slowed down considerably (in fact, since Bernanke’s “tapering speech”, junk bond yields have oscillated at very low levels in a side-ways channel). Note that due to the convexity effect, prices of long term bonds rise much more if yields decline from e.g. 4% to 3% than they do on a similar 100 basis points decline from e.g. 10% to 9%. As declines in yields slow down with yields reaching lower levels, there are in short still very large capital gains possible (e.g. the decline in 10-year German Bund yields over the past two years from a high of about 3.5% to a low of about 0.9% produced approximately a 25% capital gain).

Relative performance of HYG vs. SPX – since Q2 2013, HYG has begun to underperform – click to enlarge.

Conclusion:

The above divergences are yet another subtle warning sign. Whether they warn merely of a correction or something worse of course remains to be seen. However, the issuance of high yield corporate debt since 2009 has broken one record after another, so we continue to suspect that this market segment represents a major Achilles heel of the entire universe of “risk assets”.

Euro area stock markets have shown strong relative performance for a little while, seemingly ending their long streak of underperforming US stocks, but this has been put in doubt again by the recent action (especially when looking at a geographically more diversified cap weighted index such as the EuroStoxx Index vs. the SPX). Needless to say, in terms of aggregate economic data, most European economies have also underperformed the US economy and have recently resumed their relative weakness as well.

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Foreign Reactions to the referendum in Scotland

By William Walker

All eyes are on Scotland as the referendum nears. Governments, the media, financial institutions and hosts of groups and individuals are glued to the debate and wondering how it will end. Amidst concern there is fascination in an event that seems so unprecedented with an outcome that is so unclear. Among those fortunate enough to be visiting or living in Scotland at this time, there is exhilaration at the sight of democracy working at full tilt.

The international attention is very recent. There was hardly a flutter when the Scottish government announced in 2011 that it would hold a referendum. The Edinburgh Agreement of October 2012 between the Scottish and UK Government was a wake-up call, especially because it coincided with a nationalist upsurge in Catalonia that sparked a Spanish response (including a threat to block a future Scottish application to join the EU), and with the Scottish National Party’s adoption of a pro-NATO policy despite pledges to remove Trident from the bases in Scotland.

After a brief surge of interest, foreign governments went back to sleep and remained asleep throughout 2013. The referendum was still far ahead, and the general assumption – encouraged by London and the metropolitan media – was that the independence movement would be heavily defeated. Developments in Scotland were mainly followed, if at all, from capitals or from embassies in London. Some Consuls General in Edinburgh warned that another outcome was possible, to which their masters should pay greater heed, but they were largely ignored.

In January 2014, opinion polls unexpectedly showed a marked shift in support for the yes campaign, unexpectedly because it was believed – abroad as in London – that Scottish voters would ‘come to their senses’ when the downside of independence was fully revealed to them by the analysis pouring out of Whitehall and Westminster. At the same time, the UK government’s emphasis on provoking fear among Scotland’s voters, rather than offering a positive vision of the Union’s future, began to attract criticism in the press and among foreign observers. Contrast was also being drawn between the increasingly vibrant grass-roots campaign for independence and its lacklustre unionist counterpart. Momentum seemed to be shifting in the nationalist direction, giving rise to warnings that opinion polls could narrow further.

Encouraged by London, several governments began to debate the pros and cons of issuing statements favouring the UK’s survival. Besides Spain, they had hitherto remained silent, wary of intervention and happy to regard the referendum as a domestic British affair. President Obama’s carefully chosen words at a press conference on the 5^th of June, expressing the United States’ hope that the UK would remain ‘a strong, robust, united and effective partner’, broke the ice. A number of political leaders followed his lead. The Australian Prime Minister apart, they adopted his cautious tone, declaring their respect for Scotland’s democratic right to decide on its future whilst making clear their preference for the status quo. Although the majority, including the UK’s closest neighbours Ireland, France, Holland and Norway, have so far chosen to keep quiet, they would not disagree. Only a handful – Argentina and Russia come to mind – might relish the UK’s demise. Even they have kept quiet.

The widespread concern about the referendum among foreign governments has little to do with Scotland, its welfare and its future viability as a state and society. It is assumed abroad that a Scottish state could fend for itself and would become a stable and reliable member of the international community after a few difficult years. It has the culture, skills, institutions and resources to count among the strongest of the world’s small states.

Governments have other concerns. They do not like secession, as Scotland’s vote for independence would be regarded, wherever and however it is occurring. They worry especially about the precedent of a region within an advanced democracy claiming and being granted legal right to hold a referendum against the interest of the host state. The Edinburgh Agreement has already put the Spanish government on the spot in Catalonia where similar rights are being demanded. Correctly or incorrectly, there is worry abroad about a contagion of secession. Beyond this, states within ‘the West’ and governments reliant on its strength and cohesion do not want the UK and by extension NATO and the Western alliance to be reduced as power players, whatever the UK’s recent misjudgements in foreign policy, especially when Russia and China are flexing their muscles. And they do not welcome the political and legal problems created by Scotland’s application to join international organizations, prominently the EU, when they are already under strain. Some states have more specific concerns, including the United States over the damage caused to its closest ally, and France over the fate of Trident (it has no wish to be Europe’s sole nuclear power) and its permanent membership of the UN Security Council should the UK’s right to succession be challenged.

If the referendum does produce a yes vote, the desire in foreign capitals – with very few exceptions – is for Scotland and the rest of the UK to work together, sort out their differences, and set an example for cooperative behaviour.   They expect this to happen in the two countries’ mutual interest, however much the two sides may have huffed and puffed on the currency, Trident and other issues during the referendum debate. Their optimism is encouraged by the absence of violence and pressing need for financial stability, respect for the British state’s administrative capacities and long tradition of pragmatic adaptation, and the Scottish and UK governments’ obligations under the Edinburgh Agreement to ‘work together constructively in the light of the outcome, whatever it is’.

This said, they share worries about a yes vote’s immediate aftermath. How would London and Edinburgh’s negotiating teams be constructed? How would political parties respond? Would Mr Cameron and some other prominent political leaders be forced to resign? How would the 2015 general election be run, would its imminence hamper the launch of negotiations between Edinburgh and London, and how would the Westminster Parliament function before Scotland had gained full independence? How would governments abroad conduct relations with Scotland, on issues such as EU membership, when it was still formally part of the UK?

Above all, it is the self-confidence, behaviour and internal stability of the rest of the UK after a yes vote that provokes anxiety abroad. How would England, Wales and Northern Ireland respond to ‘the loss of Scotland’? How would foreign relations be affected? Would Scotland’s independence be the end or beginning of the UK’s disintegration as an effective political unit?

There is also awareness abroad that the UK would be a different country, if keeping the same legal personality, after a ‘no’ vote. Relationships between the political centre and periphery would have changed in the UK. A further substantial devolution of powers to Scotland and Wales will surely follow, and pressures to give English regions more political and economic autonomy are already building. Unless the referendum is defeated decisively, which now seems unlikely, there is also little confidence that Scotland’s independence will have been put to bed. The UK may have gained only a temporary lease of life.

Governments abroad don’t like the Scottish referendum. They like the prospect of a referendum on the UK’s membership of the EU even less. An anxiety abroad is that a Scottish ‘yes’ vote would make the UK’s (or rest of the UK’s) exit from the EU more likely, since it would strengthen anti-EU forces in the Westminster Parliament and remove the relatively pro-EU Scots from the voting register. In addition, they worry that the running of this referendum would inflame sentiment across Europe, creating more instability across the continent. They may be wrong. It is also possible that the shock of Scotland’s departure from the Union would force a weakened rest of the UK to reassess its position in the world, leading to realisation that life outside the EU would be too lonely and insecure to contemplate. Furthermore, the Scottish experience has demonstrated how divisive and all-consuming referendums can become. They are best avoided.

In June I wrote that, when viewed from abroad, Scotland’s departure from the UK would be an unwelcome disturbance rather than a crisis in international politics (‘International reactions to the Scottish referendum’, International Affairs, July 2014). On reflection, disturbance may be too mild a word to describe an outcome causing upheaval in the politics of an erstwhile great power. But it surely would not become an international crisis. I also wrote that ‘the unequivocal desire abroad is for both Scotland and rUK to emerge as robust states and societies having good relations one with the other. Although the first years may be troubled, there is hope abroad that the two states would overcome their difficulties and settle into a cooperative relationship. Indeed, their governments’ international prestige would depend on, and be boosted by, their evident willingness and ability to work together for the common good’. I hold to this opinion.

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Can Real Estate Stocks Cope with Rising Rates?

by Eric Franco

After a sharp five-year rally in US real estate stocks, investors are questioning whether they may be vulnerable to a rise in interest rates. Our research suggests that global real estate stocks may be more likely to weather a changing rate environment.

US real estate stocks, commonly organized as REITs, have been strong performers since the global financial crisis. The FTSE NAREIT All Equity index of US real estate stocks has climbed 20% in 2014 through August. Since March 2009, the index has nearly quadrupled—outpacing both global property stocks and the broader US market. No wonder that US mutual fund investors have pumped $28 billion of net inflows into US real estate stocks over the last three years, in contrast to just $8 billion for their global peers.

Why all the love for US REITs? Despite the recovery in global equities, investors still seem to prefer securities with relatively safe and secure cash flows, including both bonds and higher-yielding stocks such as utilities and REITs.

US REITs have been especially prized for the relative safety of the US and improving cash flows of the stocks, bolstered by steadily improving demand in an environment of limited new supply of commercial properties such as office buildings and retail malls. But while US property market fundamentals remain quite healthy, the valuation of US REITs isn’t nearly as attractive as a few years ago—even when compared with government bonds.

Comparing US and Non-US Real Estate

Outside the US, it’s a different story for two reasons. First, valuations of non-US real estate stocks look relatively attractive. For example, the cash-flow yield for US real estate stocks versus the 10-year Treasury—a widely used valuation metric—is now only slightly above its long-term average, even with interest rates at rock bottom. In contrast, the cash-flow yield for non-US real estate stocks relative to a composite of 10-year sovereign bonds remains well above its long-term average (Display). And, as in the US, fundamentals are generally healthy for property stocks outside the US, with improving demand and limited new supply in most major markets.

More than Just a Bond Proxy

Second, non-US real estate stocks prices have recently been less sensitive to changes in sovereign yields. We analyzed the correlation of changes in sovereign yields with the outperformance of overall equity-market returns relative to real estate stock returns, both inside and outside the US. The trend varies over time. But today, this correlation is near a record high in the US whereas it is about average outside the US (Display). In other words, US REITs recently have reliably outperformed the S&P500 when Treasury rates declined and have reliably underperformed when rates rise, probably because investors are treating US REITs as bond substitutes given their perceived safety. But non-US REITs have generally not behaved as a sovereign-bond proxy in the same way.

Non-US REITs offer another advantage because they are exposed to diverse interest-rate environments. Today, in several major markets like Japan, the euro area and Australia, low rates are still embedded in the financial landscape and are unlikely to rise soon.

So by looking beyond the US, we believe that investors can stay in real estate stocks without returns being too tightly linked to sovereign yields. For those who still want the steady cash flows and dividends that real estate stocks can offer, we think global REITs may be a good way to maintain exposure to the asset class while reducing the vulnerability to rate hikes.

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Hedge Funds Lower Crop Bets to Lowest Since January

By: Bloomberg

Hedge funds cut bullish wagers on agricultural commodities to the lowest since January before the U.S. forecast rising grain supplies and sent wheat, corn and soybean prices to four-year lows.

Money managers lowered their net-long position on crops from coffee to wheat in 10 of the past 11 weeks, U.S. government data show. Investors got more bearish on sugar and have the most-negative outlook on soybeans since 2006.

American farmers will collect the biggest corn and soybean crops ever this season, while global wheat reserves are set to reach a three-year high, the U.S. Department of Agriculture said Sept. 11. Three months of rain and mild weather created almost ideal growing conditions, spurring price declines that drove the Bloomberg Commodity Index to a five-year low last week.

"The weather’s been very conducive for a very strong crop," Kelly Wiesbrock, a portfolio manager at Harvest Capital Strategies in San Francisco, which oversees $1.8 billion, said in a telephone interview Sept. 10. "We’ve completely rebuilt inventory levels from a couple years ago. They’re no longer tight, and you’ve seen corresponding prices drop a lot."

The Bloomberg Commodity Index fell 2.8 percent last week, the most in two months. Corn futures in Chicago tumbled 4.9 percent, the most since July 11, to $3.385 a bushel on the Chicago Board of Trade. The MSCI All-Country World Index of equities slid 1.4 percent. The Bloomberg Dollar Spot Index rose 1.2 percent.

Farm Wagers

Combined net-bullish positions across 11 agricultural products fell 14 percent to 237,297 futures and options contracts as of Sept. 9, Commodity Futures Trading Commission data show. The wagers are down 79 percent from this year’s peak in April.

Global corn stockpiles are projected to reach a 15-year high before the 2015 harvest, with production climbing in the U.S., Europe and Brazil. Soybean output will rise to the highest ever, at 311.13 million metric tons.

World food prices retreated in August to the lowest in almost four years, the United Nation’s Rome-based Food & Agriculture Organization said Sept. 11. The index for cereals declined for a fourth straight month, dropping 13 percent since April.

Low prices may not last if buyers expand purchases of cheap supplies. Traders will shift their focus to robust demand "in coming months," with corn futures "trending back towards $4," Christoper Narayanan, the head of agricultural research at Societe Generale, said in a Sept. 12 report. Global consumption will rise 2 percent this season to 970.69 million tons, the USDA predicts.

Yield Risk

Freezing temperatures and excessive rain can still threaten to reduce corn and soybean yields before harvesting begins at the end of this month in most of the northern half of the Midwest. The U.S. is the world’s biggest grower of corn and soybeans and the top exporter of wheat.

"If you were to get a sharp U-turn in prospects for the really nice weather we’ve been having, some kind of frost or winter-type blast, that would" help support prices, Sameer Samana, a senior international strategist who helps manage $1.4 trillion at Wells Fargo Advisors LLC in St. Louis, said in a telephone interview Sept. 11. "It would be a short-lived rally."

The net-short position in soybeans reached 39,786 futures and options last week, the CFTC data show. That compares with 25,574 a week earlier and is the biggest bearish holding since October 2006.

Crude Wagers

Net-wagers across 18 U.S. traded commodities tumbled 8.4 percent to 511,424 contracts, the lowest since November, the government said.

Bullish bets on crude oil climbed 8.3 percent to 186,612 contracts. West Texas Intermediate last week slid 1.1 percent to $92.27 a barrel in New York and traded at $91.57 today. Speculators turned bearish on copper, with a net-short position of 2,077 contracts, compared with net-long a week earlier of 6,657 contracts.

Investors reduced bullish bets on gold for a fourth straight week to 71,376 contracts, the lowest since June. Futures in New York are heading for the first quarterly loss this year.

Even as the U.S. expanded sanctions against Russia and ramped up its military campaign to combat Islamic State in Iraq, investor interest in bullion has been muted as the U.S. economy recovered. Improved prospects for faster growth have boosted speculation that the Federal Reserve will signal a move toward raising interest rates at its meeting this week.

"Gold’s been a tough investment on the long side for a considerable period of time," Jim Russell, who helps oversee $120 billion as a senior equity strategist at U.S. Bank Wealth Management in Cincinnati, said in a telephone interview Sept. 11. "We’ve had a lot of negative world news, and gold has not rallied in the face of that. And I don’t know of any more terrifying headlines to produce than are being produced now."

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Why Scotland Has All The Leverage, In One Chart

by Tyler Durden

As Scotland prepares to vote for or against Independence from the Union on Thursday, it appears everyone has an opinion on what may, what should and what will happen. At the basis of every such opinion is some basis in fact, misguided as it may be in most cases, about who has all the leverage, with the dominant one being that Scotland would make a horrendous mistake if it says goodbye to the UK and puts a border around what is currently a third of UK's landmass.

Some, such as Deutsche Bank, the bank that has the single greatest derivative exposure in the world and is therefore most leveraged to maintaining the status quo, saw its "Chief Economist & Member, Group Executive Committee, Deutsche Bank AG" David Folkerts-Landau personally put pen to paper on Friday and in rambling, demagogic terms, explain why it would be a "Wrong Turn" for Scotland to seek self-determination.

He says that, "A "Yes" vote for Scottish independence on Thursday would go down in history as a political and economic mistake as large as Winston Churchill's decision in 1925 to return the pound to the Gold Standard or the failure of the Federal Reserve to provide sufficient liquidity to the US banking system, which we now know brought on the Great Depression in the US. These decisions – well-intentioned as they were – contributed to years of depression and suffering and could have been avoided had alternative decisions been taken." Sure, there could have been no gold standard and the Fed could have gone full-Bernanke, and it would only have kicked the can a few years leading to an even greater depression, as the recent paradigm of "bubble to bubble" transitions, described by none other than Deutsche Bank, is where the world finds itself. In fact, it is DB that admitted last week that without a bubble, the western financial way of life is finished.

DB's Landau concludes with the following outright propaganda:

Most importantly, the world as it is evolving in the 21st century is a highly uncertain place with unstable geopolitics and a stressed economic and financial outlook. Why anyone would want to exit a successful economic and political union with a G-5 country – a union which another part of Europe so desperately seeks to emulate – to go it alone for the benefit of... what exactly, is incomprehensible to this author.

Well, maybe let's ask what is increasingly a majority of Europeans across the ill-fated and artificial Eurozone, whose fixed currency means the only devaluation possible is internal, read crashing wages. But of course, the head of something or another at Deutsche Bank has nothing to worry about in this regard.

And yet, as always, the bottom line is about leverage and bargaining power. It is here that, miraculously, things once again devolve back to, drumroll, oil, and the fact that an independent Scotland would keep 90% of the oil revenues! As we showed several days ago, Scotland's oil may be the single biggest wildcard in the entire Independence movement.

It is this oil, and its interconnectedness within the UK economy, that as SocGen's Albert Edwards shows earlier this morning, is what gives Scotland all the leverage.

From Edwards:

it is increasingly likely that it too it will be joining Scotland in permanently exiting the EU club. First of all, consider the vulnerability of sterling after a Yes vote for Scottish independence. Even without North Sea oil revenues, the UK current account situation is a mess. The left-hand chart below is one I put up at the end of our flagship conference in January this year. The point I made was it is absolutely extraordinary for the UK to be beginning an economic cycle with a current account deficit of around 5-6% of GDP. Normally this is a level the UK or any other developed countries get to at a height of a boom after years of overspending on consumer imports. I think I described the UK position as an economic abomination of the highest order and that this economic cycle was likely to end some years from now in a calamitous sterling crisis - just like we used to have in the past.

Our specialist macro salesperson, Richard Walker, thinks that it is in the rUK's economic interest to retain some sort of currency union with Scotland after independence as he points out Ireland did after its own independence in 1922 until 1979. He believes the maths for the rUK just don't add up - on the basis of an independent Scotland keeping 90% of the oil revenues the rUK current account deficit for the full year would have been around 7% of GDP instead of 4½% (also see right-hand chart above).

There's that pesky "mathematics" again. Here is what the math reveals:

Personally I don't believe that the rUK will conceive it possible that any continued currency union is feasible after independence having observed the eurozone mess. That means the yawning fault line in the UK's economic situation will be revealed for all to see. Indeed since we used that chart of the UK's current account mess in January this year, the deficit in Q3 last year was revised from 5% to 6% of GDP! That horrendous deficit persisted in Q4 at just under 6% of GDP but improved somewhat in Q1 of this year to 4.4% of GDP. That improvement though to me looks erratic and liable to reverse, most especially as the trade deficit through July continued to deteriorate. So, if rather than the 2013 full-year UK current account  deficit of 4½% of GDP; the underlying situation is more reflective of the almost 6% deficit seen in H2, then the rUK current deficit will be nearer to 8 1/2% of GDP! The UK is due to release its 2014 Q2 Current Account data on 30 Sept.

For the UK as a whole the current account deficit is awful. For the rUK it is simply untenable. If investors are selling sterling in anticipation of a Yes vote, the economic reality of a rump rUK will see sterling quite rightly plunge into the abyss way before the end of the economic cycle (where we previously expected the turmoil would come).

Which also means that contrary to the UK's fire and brimstone, it is the UK that has much more to lose in a world in which Scottish oil output is suddenly unavailable to plug current account deficit gaps, something the US has been able to do in the past 5 years courtesy of the transitory shale boom.

The vulnerability of sterling in a rUk world is made much worse as investors come to grips with the increasing prospect that the rUK will be leaving the EU. Capital will not be moving from north of the Scottish border to the south. It will be moving out of the UK altogether. And, with the rUK needing to attract capital at an unprecedented avaricious rate for this point in the cycle, this ain't going to be pretty. Interest rates, which are probably set to rise next year anyway, may be set to rise a whole lot faster than anticipated if we get a good old-fashioned sterling crisis, with the good old-fashioned inevitable recessionary consequences thrown in.

The bottom line, at least to Edwards, is that Thursday's vote will set in motion the independence not only for Scotland, but for the UK from the EU club:

So in the event of a Yes vote in the imminent Scottish referendum I would expect both Scotland (involuntarily) and the rUK (voluntarily) to find themselves outside of the EU club.

And should that happen, all bets are off for the continued existence of the greatest "unionization" experiment in modern history: Europe itself.

We saw similar trends towards political extremes to a greater or lesser extent in the beleaguered GIIPS (Greece, Italy, Ireland, Portugal and Spain) during the crisis. As Dylan has previously explained, political extremism becomes a very attractive proposition when a country comes under stress. Europe has a long history of such tendencies. Separatist and nationalist movements throughout Europe are gaining a stronger foothold with nationalist fault lines previously thought dormant awakening in unison right across Europe - see for example this interesting article from Ambrose Evans-Pritchard - link. The outcome of a Yes vote in Scotland may have as unpredictable consequences as did events in Eastern Europe in the late 1980s. A yes vote will send the EU bicycle (or if you prefer, shark) into reverse for the first time since the 1957 Treaty of Rome, with wholly unpredictable consequences.

Good luck, Scotland. The fate of a century of globalization and wealth-transfer efforts suddenly lies on your shoulders.

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