"Deflation In Europe Is Just Beginning"... And How To Trade It

by Francesco Filia

Deflation in Europe is Just Beginning

Differently than Russia/West crisis, the problem of deflation in Europe is far more structural of an issue, likely to hold the stage for the foreseeable future.

As often stated, we believe Europe looks like Japan in the early 90’s. Similarly to Japan, Europe has few unmistakable connotations at interplay:

• High level of indebtedness, drawing resources away from productive investments into sterile debt service.
• Overvalued currency, especially to peripheral European countries (30% overvalued against D-Mark, 40%+ overvalued against the rest of the world). Peripheral Europe is experiencing a currency crisis as if they borrowed in foreign hard currency.
• Secular trend of falling working population mixed with falling productivity rates.

The data released in the past few weeks provided evidence of European growth having grounded to a halt for most countries, including Germany. Italy dipped in triple-dip technical recession, while France slowed down concerningly and even Germany contracted in Q2. All the while, inflation averaged 0.3% for the Euro Area as a whole, well below the ECB target and on a clear downtrend.

In Japan in the early 90’s, it took four years for disinflation to become deflation, under the push of a strong Yen and with the help of an inactive Central Bank dismissing such risk until late.

Likewise in Europe, the EUR is far too strong when measured against GDP growth prospects and productivity trends. A misleading current account surplus of 200bn only managed to make it stronger (overshadowing imbalances across countries in Europe), together with a shrinking balance sheet of the ECB for almost Eur 1 trn on deleverage flows and LTROs repayments.

In crafting crisis resolution management, European policymakers blamed the lack of reforms for the low levels of productivity, whereas Europe was suffering from a structural lack of demand. A much more dominant problem. Given that, the ECB balance sheet was allowed to shrink for almost two years now, the EUR was allowed to strengthen against most currencies around the world (which were actively engaging in the opposite effort, one of bold currency debasement, ranging from the US, to the UK, to Japan.. including even Switzerland and Norway), and austerity was imposed to shrink fiscal deficits. The candidly stated goal was to drive Internal Devaluation across peripheral European countries, so as to close the competitiveness gap to northern Europe: output contractions, wage declines, fall in prices. Almost the opposite of what should have happened if the problem was diagnosed as one of deficient demand. Tightening fiscal and monetary policies took place in Europe for two consecutive years, all the while as most other large economies were engaging in the polar opposite.

Nomen omen. Internal Devaluation in Southern Europe is itself an intentional form of deflation. It should have been confined there where it mattered to level off imbalances across nations in Europe. Instead, the laboratory experiment failed as it metastasized around.

Globally, other structural forces were inductive of deflation, from robotics and technological advances shedding jobs and depressing input prices (the Amazon effect), to low energy prices (on shale gas revolutionary discoveries and the end of the Commodity super-cycle), to weaker than potential growth, slack in the labor market, weaker dollar on ZIRP policies, Yen devaluation exporting deflation, China slowing down, etc.

The result is that Germany’s GDP itself is in tatters, even before considering the damage to be from trade wars with Russia. Deflation took hold and derailed the improvement in the soft data and surveys projected earlier on.

The problem with deflation is that minuscule levels of GDP growth are unable to drive unemployment lower and unable to prevent debt ratios from grinding higher and posing a larger threat down the line. Mathematically, as primary budget balances are lower than the difference between real GDP growth and real interest rates on public debt, the debt/GDP ratio is set to rise, from already alarming levels.

Italy, is the main vulnerability here, as a debt/GDP ratio might reach 140% by the end of this year, thanks to disinflation and GDP contraction, and despite austerity and a 2% primary surplus on GDP. By the same token, thanks to zero inflation rates, real rates are too high in Italy, standing at over 200bps above France and 250bps above Germany.

Zero inflation is like death penalty to debt-laden countries. It has been estimated that Italy would need a primary surplus of ~8% if it wanted to stabilize its debt/GDP at zero inflation, which means just stopping it from moving even higher. Spain would need a primary surplus of 2%+, instead of current negative 1.44%. Which means more austerity and more contractionary policies, to cause more internal devaluation than it is currently the case, more declines in unit labor costs, more salary cuts, more unemployment, less consumer spending, less corporate investments. In Italy, for example, average salary would have to be cut by an additional 30%/40% before closing the competitive gap to Germany. This does not account for the fact that inflation in Germany is itself on the verge of becoming negative, making the necessary adjustment even more painful than that.

The good side of the story is that we believe that the ECB and fiscal authority will be forced into further action from here, in an attempt to avoid a fully-fledged debt crisis and a long period of Japan-style depression.

Germany is the key determinant of European policymaking, all too obviously, and we believe they might be about to give in to request for expansionary policies, both fiscal and monetary.

Few reasons for it:

• The German economy itself is contracting, hardly a satisfactory result after many years of implementation of their policy recipe.
• German inflation itself is borderline negative. Europe-wide inflation expectations have dis-anchored from 2% desired line, falling off 20bps in August alone (both 10y and 5y5y forward inflation swap curve). Any concern about price stability and Weimar-style inflation risk should have been put to rest by now.
• German concerns with moral hazard on the side of weaker European member states should have abated by now, as most political parties have embraced structural reforms as essential, and married their political agendas to it. Government in France, Greece and Spain have already spent their political capital embracing the German agenda, being now certain to lose in future elections, while the Italian government is close to do the same, having credibly committed itself to reforms. Germany faces the best mainstream political parties in Europe they can aspire to; any future coalition is most certain to be less receptive of German’s diktat than these ones. The calendar of national elections across Europe next year and beyond should serve as a countdown. Thus, we believe Germany should be prepared now for a relaxation of austerity policies and spreading the adjustment process of fiscal consolidation over a longer time horizon, while opening up to real monetary stimulus.
• Confrontation with Russia, while it may ease over time, surely highlights the urgent need for a common defense policy / energy policy across Europe, helping the case for integration in Europe in the short-term, softening German resistance to more expansionary policies.

In summary, we believe the ECB will be allowed to engage in non-conventional monetary policies, their version of QE, pushing equity and bonds higher in Europe, compressing spreads and yields further, within the next 6/12 months.

Whether it is going to be enough to avert a currency/debt crisis in Europe in the long run is a different matter. We think that there is a genuine case to be made for seeing dissolution of the currency union down the line, in an attempt to save the European Union. Early days to visualize that, though. What matters to the financial markets is the next twelve months - the foreseeable future - and we believe the next twelve months to be highly supporting of financial assets in Europe, both bonds and equity.

Incidentally, we have for European assets and the ECB the same feeling we have for Japan and the BoJ. Abenomics has a high chance of failure, in the long term. Nevertheless, on the road to perdition, chances are that efforts will be stepped up and more bullets shot in an attempt to avert the end game. As stakes are raised, financial assets will be supported and melt-up in bubble territory, doing so at the expenses of a more turbulent end-game in the years ahead.

Implications of Deflation + ECB’s Activism: Yields & Spreads to Compress to Minuscule Levels, Equity Melt-Up First

As discussed in our previous Outlook, ECB policies and deflationary forces are two weapons firing in the same direction. From here, odds are high for European rates to move lower, credit spreads to narrow, risk premia to implode, interest rate curves to go flatter. That is financial repression at its best, with the added help of deflationary forces, putting any sort of risk premia and rate differentials under attack.

Without the ECB policy move, such process was less obvious. In the absence of an active ECB, such deflationary forces could have failed to drive rates lower and spreads narrower, as credit and risk spreads could have widened massively on fears of a replay of the sovereign and liquidity crisis of late-2011, mid 2012. Credit spreads could have widened out well in excess of base rates moving lower. An active ECB, moving decisively and unanimously (including Weidmann), helps generate the expectation of mutuality across Europe, rendering deflationary expectations even across European countries.

From our June Outlook: ‘’Pushing lower a 10year German bund yield of 1.35% might be difficult (although Japan shows the downside is still wide), but forcing lower a 2.75% yield on a BTP is easier, as it offers twice the yield of a Bund, for the same Central Bank. So it is easier to push down a 6% yield on a Greek govie (and its CDS at 450bps over), on the presumption of mutuality and ECB backstop. For the time being, until further notice’. Fixed income-wise, we expect yields to plummet, spreads to narrow further: Italian BTPs at 2%, and at 100bps spread over Bunds, 60bps over French OATs; 10year Greek yield at 5% and below, soon enough’’.

The impact on equity we expect is one of melt-up, at least in a first phase, pushing them into bubble levels, not supported by fundamentals but rather by the mix of lower yields, zero inflation rates, modest economic growth. Against this backdrop, we believe that the activism of the ECB can lead into 20%/30% upside for equities in Southern Europe, especially in the financial industry. Our favorite markets are Italy and Greece, which we think have the potential of being best performers in the next 12 months, although with heavy (realized) volatility along the way.

European Deflation Trades

Disinflation is just about to turn into outright Deflation in Europe. The ECB is active but most likely already late in the game, behind the curve, and unable to prevent deflation from kicking in. There are important consequences for rates and spreads in Europe, together with the level of the EUR itself:

• Rates to reach new lows, especially in the far end of the interest rate curve, especially in Germany. Bunds 10yr yields moving flat to JGBs, Bunds’ 30yr yields below JGBs
• Spreads to compress, both between peripheral debt and core European debt, and across the curve. Italian 10yr BTPs at 2% yield by year end, and at below 100bps spread over Bunds, below 60bps over French OATs; Greek 10yr GGBs at below 5%
• Risk premia to implode, interest rate curves to flatten. Curve spreads to tighten, volatility spreads to compress, cross-spreads to narrow.

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Black Swans Possible for Grains

By: Jerry Gulke

October USDA reports often significantly influence the extent of harvest lows as well as any post-harvest recoveries. This year might hold a surprise.

With so much attention placed on just how much yields will exceed records, there might be room for optimism rather than the gloom and doom markets are reflecting. The Gulke Group crop survey estimates were never as lofty as some but rather in line with corn intentions of about 90.5 million acres. Factoring in about 1.5 million prevented planting acres, a figure announced in August by USDA’s Farm Service Agency (FSA), we revised our number to 89 million acres planted to corn.

Preliminary certified acreage data from FSA provides opportunity to evaluate changes USDA might make in October’s Crop Production report. One interpretation is USDA’s 2014/15 corn planted and harvested acreage estimate could fall by 2.5 million acres. Late plantings, reduced growing degree days and yet-to-be-numbered flooded acres suggest acres harvested for grain could drop more. USDA hinted at the possibility, reducing harvested area by 400 million acres.

Harvested acreage totaling 80.8 million acres, instead of the 83.8 million acres in USDA’s August estimate, would produce crop of 13.736 billion bushels with the 170 bu.-per-acre yield assumed by the trade plus carry-in. That’s only about 300 million bushels more than USDA’s estimated demand of 13.435 billion bushels, raising ending stocks to only about 1.4 billion bushels. That hardly produces an oversupply of 2 billion bushels the market seems to be discounting.

If corn yields reach 174 bu. per acre, it will add 320 million bushels and get carryover closer to 2 billion bushels. That would leave room for a demand surprise, reducing the need for prices to rise beyond $4.50 in the lead contract unless 2015 weather becomes a factor.

Soybeans appeared to be in trouble price wise starting with our early acreage survey.  The market offered a financial incentive to plant soybeans at the expense of corn. Corn prices plunged in May as corn plantings lagged, especially north of Interstate 90. In June, USDA raised soybeans to 84.8 million acres, well above my March estimate of 83.5 million acres.

This past month, FSA’s acreage announcement implied a possible 1.5 million-acre reduction to 83.3 million acres planted and 82.5 million acres harvested. That would calculate carryout at about 375 million bushels using a soybean yield of 47 bu. per acre with a good finish in the Dakotas and USDA demand expectations of 3.535 billion bushels. That is much less than the 440 million bushels some expect. It will hold true unless soybean yields top 47 bu. per acre including in the Dakotas, where 10.5 million-plus acres of soybeans were planted.

Alternative Surprise Scenarios. If a significant oversupply is to be averted, there needs to be an October acreage shock or a mid-September freeze. Absent a freeze, hope will lie in the prospect that U.S. producers heeded market signals and reduced corn acreage more significantly than the trade believed and that the cool, wet summer and fall dampened yields. If none of those events transpire, we’ll need either a demand-building phase for perhaps 18 months or a period of waiting until low prices result in fewer planted acres in 2015.

A final surprise this year might be the efficiency with which producers tuck crops into increased grain storage, particularly in northern areas with a wide basis. With cash corn well under $3 in the northern Plains, it seems rational to store below the cost of production and earn the market carry rather than to produce more of the same next year.

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What international crisis will rile markets? It may not be what you think.

By Yesenia Duran

It has been a long hot summer of conflict as numerous geopolitical events have sprung up around the globe creating uncertainty with a threat of larger conflicts, which could upend markets and the fragile golobal recovery from the 2008 financial crisis.

Oddly these numerous hotspots has not translated into a spike in volatility but each is just one miscalculation away from an escalaition that could create a global market crisis.

Israel and Hamas have been invovled in a hot war in the Gaza strip while the Syrian civil war has spillled over into Iraq and a new radial Islamic group has emerged to threaten the region. Russia, not content with the annexation of the Crimea, has supported separatists in Ukraine threatening Western Europe and forcing it to choose between energy needs and the threat of old style Soviet expansion. Libya is still unstable as is much of North Africa.

With all this going on in the usual regions China and Japan--the second and third largest economies in the world--have their own conflict quietly brewing. 

While global conflicts often spark and then fizzle, with so much going on there is a chance one of these conflict escalates to an event that can have a dramatic effect on markets.

We thought this was a good time to ask our experts the following question: The world is awash in geopolitical risk. What countries/crises should you be watching (as a driver of price) and why?

Here's what they said.

Carl Larry

In oil we’ve come full circle as investors are coming back into the oil space. We’ve lost a lot of the big banks thanks to Dodd/Frank, but the fund money has been finding its way back. The difference is that instead of these macro funds coming in trying to learn how oil reacts to geopolitical risk, it’s now about the way that the oil markets react to macroeconomic events. Back in the 2000’s the risk was to the supply amidst geopolitical events, but now it’s about the risk of global economic risk and the effect on demand.

In the oil market the geopolitical events are getting less attention than a celebrity photo leak of the Golden Girls. What I do think is important to watch though is the effects of Russia will have on the EU. There has been a lot of hope bubbling up lately in the EU that as the U.S. refinery system heads into maintenance season (Sept-Nov) they might be able to pick up the slack and start making money again on imports here. Now if Russia tightens the natural gas supply to the EU, the higher costs for power generation are going to eat into any of those profit margins. Another stumbling block in the oil demand for everywhere but in the United States.

At the end of the day though, if the EU can’t make up any lost production of refined products in the US during this year’s maintenance, we’ll see oil prices here in the US get an unseasonal rally as our demand is going to outpace the loss in supply. 

Matt Weller

It feels as if there are an inordinate number of geopolitical events that are at risk of boiling over as we head into autumn. A fragile peace between Israel and Gaza, ongoing violence from ISIS in (Syria and Iraq) and the continuing conflict between Russia and Ukraine are the most salient risks for traders at the current moment, but the situation that could have the largest impact is China and Japan’s dispute over the Senkaku Islands.

For the uninitiated, the Senkaku Islands are an archipelago of uninhabited islands in the East China Sea that both Japan and China have laid claim to at various points over the last few centuries. Inhabitants of the two countries generally despise one another (a recent BBC poll showed that 73% of Japanese people view China negatively, while an incredible 90% of Chinese individuals view Japan negatively) and two governments’ dispute over the islands represents a matter of national pride.

Kara Boniecka

I take a somewhat contrarian view of geopolitics. Throughout history, there have been all manner of risks threatening global markets. This hasn’t and probably won’t ever change.  What does change is our awareness of these risks.  And that’s what makes predicting market movement on geopolitics so tricky. There are myriad ways in which our awareness of political situations can bubble to the surface. The timing of these catalysts is often difficult to predict.

What we can say is that when these factors do take hold of the collective imagination there are often three major impacts: i. a repricing of risk premia, which has investors demand higher returns on riskier assets, ii. an increasing risk aversion, which has them delay putting capital to work as they wait for “things to quiet down,” and iii. the discounting of deserved positive news as bleak portrayals of world conditions become accepted knowledge.  These have the net effect of increasing volatility and destabilizing momentum moves.  The good news is that this often brings fundamentals back into sharp focus.

So, what I watch for is not so much activity in a particular region or country, but rather threats that are imminent and not yet well-publicized. These are the ones that have potential to move markets substantially.

Dan Gramza 

Geopolitical risk and crises create uncertainty. Stock markets hate uncertainty and the commodity markets love uncertainty. Therefore, you expect stock markets to go down in reaction to fundamentals that create the anticipation of a future event or the specifics of particular action that has been taken.

Here is my take on a few key locatiions.

Although the euro area economic situation has calmed down, it has not completely recovered. My outlook is positive for this recovery to continue. A basic barometer to monitor are the 10-year interest rates for these countries. When a countries 10 year interest rate goes above 5%, the markets begin to be concerned. The concern increases dramatically when the 10 year rates increase above 6% and above 7% it is expected the country will need financial help. Current ECB actions have dampened market concerns about the economic stability of this region.

Ukraine/Russia: This conflict can dig deep into the health of European economies and can have long-lasting impact on international relationships.  All indications are that Putin has an agenda and is intent on implementing the agenda.

Iraq: Iraq was expected to provide 60% of OPEC growth for the rest of this decade. Iraq produced 3.3 million barrels per day of crude oil in May. Baiji is the largest Iraqi oilfield and it is located about 130 miles north of Baghdad and who will have control of this is in doubt. Approximately 75% of Iraq’s oil production is in the southern part of the country and so far has been uninterrupted. Remember, if there is an interruption of crude oil flow from Iraq or Libya, Saudi Arabia has excess capacity to cover the shortage.

John Caiazzo

I am concerned about a number of geopolitical situations: Gaza/Hamas Israeli conflict where the cease fire appears to be only to allow Hamas to regroup in my opinion. Also the continuing incursion into Ukraine by Russian military machine.

Matt Weller

China is the world’s second largest economy and Japan is the third largest, so if this situation escalates later this year, its trading impact could dwarf the impact of any of the above conflicts. While everyone else is focusing on the geopolitical minnows right now, astute traders will be watching to see whether the geopolitical whale of a risk between China and Japan will rear its head later this year.

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Have We Reached a Financial Singularity?

by Charles Hugh Smith

Encouraging and supporting asset bubbles is essentially the only force remaining to keep the system intact as we know it.

The Singularity is based on the idea that machine intelligence will soon exceed human intelligence, and human history is unknowable beyond that point. This concept draws from a variety of sources, but for me the foundational idea comes from the physics of black holes, in which gravity concentrates the material of a collapsing star into a point of infinite gravitation, i.e. a singularity, that is surrounded by an event horizon that marks the line beyond which observers will inevitably be pulled to their destruction in the black hole. Observers cannot go back once they cross the event horizon, but they cannot see the inside of the black hole without going beyond the event horizon.

Longtime correspondent B.C. recently proposed that the global stock markets have reached a Financial Singularity in which trading machines now control the markets. Here are excerpts of B.C.'s emails on the topic:

In some respects, "The Singularity" has occurred in the financial markets, only humans are incapable of perceiving it except by inference.I will reiterate from the past my assertion based on direct and highly suggestive personal evidence that the major US, UK, and EZ equity markets are being "managed" offshore by the TBTE (too big to exist) banks' dark pools' pass-through entities in the Caribbean banking centers, levering up US Treasury and MBS (mortgage-backed securities) holdings to jam equity index with the assistance of NYSE-Euronext exchange-sponsored HFT (high fequency trading) at the price margin.

Were the discerning investing/speculating public to learn of the process, its objective, and successful outcome to date, I strongly suspect that most would approve, permitting the scheme to become institutionalized and expand to additional asset classes.

Within this context, then, in the event of another bear market or crash, I fully expect the central banks will overtly print to buy bank and insurer stocks, as well as equity index futures, perhaps not unlike the way POMOs are conduct with weekly announcements about purchases, run-offs, rollovers, and various portfolio-balancing actions. There is nothing in the Fed charter that would prohibit any of this.

Given the hyper-financialized economy and society we now have, including profits of 10-11% og GDP, financial profits/GDP at 4.5-5%, and net annual flows to the financial sector exceeding annual growth of nominal GDP, banking system liquidity, leverage, and bank book entry profits, encouraging and supporting asset bubbles is essentially the only force remaining to keep the system intact as we know it. (CHS emphasis added)

The Fed officials and their TBTE bank owners and their rentier Power Elite owners and benefactors all know this better than anyone, and I cannot today conceive of why they would pull the plug on the bubble-pumping process at this point.

Though the fat thumb of manipulation has long been discernable in market action-- the "ramp and camp" of up days, when markets open high and stay there with virtually no change, the absurd regularity of end-of-the-day "saves" when a down day is magically reversed in the final minutes into an up day--there is a mountain of more direct evidence that central banks and states are propping up markets to serve their perception management purposes: an ever-rising market projects an image of prosperity and rewards the few who own the assets bubbling higher in value.

It's Settled: Central Banks Trade S&P500 Futures (Zero Hedge)

B.C. went on to explain why the Elites who own most of the stock market wealth have no need to sell their shares, even in a sharp decline:

With 40% of financial wealth concentrated to the top 1% and 85% in the top 10%, and the largest share of increase in net flows and income derived therefrom within the top 0.1-0.5% (increasingly circulating between the top-performing hedge funds, private equity, etc.), one can make the case that wealth and income inequality is in effect as high as it has ever been, even going back to the 19th century when most people had farms/homesteads, livestock, equipment, timber, and lived in villages and towns with little access to credit and a cash economy.Today, the bottom 80-90% have effectively no net financial wealth outside of imputed real property "equity", which is in effect the lender's "equity" until the mortgage debtor borrows his own "equity" from the lien holder.

This extreme wealth inequality and hoarding of overvalued financial assets at no velocity in the rest of the economy exacerbates the drag effects of indebtedness of the economy, reducing velocity further and growth of economic activity overall.

The unprecedented hyper-financialization and associated indebtedness and wealth concentration permit the financial markets, and the top 0.1-1% who own a controlling share of the assets, to increasingly detach from the activity of the underlying economy, which is effectively not growing per capita and after price changes.
This situation is similar to Japan since the early 2000s and in the late 19th century, although the dividend in the 1890s-1900s averaged 5% compared to 2% today. But the low dividend, low or no prospective real total return, low inflation, slow or no growth of real final sales per capita, and low discount rate is practically Nirvana-like conditions for the top 0.1-1% rentier hoarders.

Because of the low discount differential to rates, dividends, and expected CPI, equity implied volatility will be lower but so will total returns. The top 0.1-1% are in "the domain of gains" and can afford NOT to need to earn a return above the low discount rate.

In other words, those who own most of the financial assets and receive the largest net flows and income from financial assets don't have to sell, nor is there a net benefit from selling at the low capital gains tax rate and 0-2% discount rate.

If those who control leverage and equity index futures prices and forward hedging at the margin are similarly influenced and situated, which they generally are, they have little motivation to pull the plug and ruin nearly perfect conditions for maintaining the status quo.

That's a long-winded explanation for "the top 0.1-1% don't need to sell, therefore, they won't."

Thank you, B.C., for explaining the Financial Singularity: those programming the trading bots and high-frequency trading machines have every incentive to push equity valuations ever higher, and no meaningful incentives to sell. Meanwhile, J.Q. Citizen is delighted to see his IRA, 401K, pension fund, etc., rise in value due to the permanent levitation of stocks.

The question all this raises in my mind: could all these forces of financial gravitation lead to an unforseen implosion, a financial black hole that neither money nor wealth can escape? Those operating the machines are confident they control all the inputs and can calibrate the Financial Singularity to produce the desired output: ever-higher stock markets.

But complex systems are not entirely controllable--even with the amassed intelligence of thousands of trading bots and HFT machines. The only way to control the markets is to own all the assets, and perhaps that is the end-game of the Financial Singularity.

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Putin plays cat and mouse with Russian online critics

By Alissa de Carbonnel

MOSCOW (Reuters) - Before the Internet, Anton Nossik remembers painstakingly copying out Soviet dissident Joseph Brodsky's forbidden writings on a clattering typewriter for samizdat publications.

On his popular blog, the online media entrepreneur now instructs readers on ways to use new technology to get around online censorship, warning them: "There's not much time left."

With an estimated 75 million people online in Russia, up from just 2 million when Vladimir Putin came to power in 1999, the reach of the Internet dwarfs that of the clandestine texts shared, at high risk, among intellectuals during the Cold War.

Where elderly Communist librarians once stood guard over copy machines, activists say a slew of regulations this year aim to police the web at one step removed, enabling authorities to target leading dissenting voices, lean on social networks and telecoms companies and encourage self-censorship.

"All the people I've had time to speak with so far in the industry are afraid and confused," said Dmitry Marinichev, who was appointed Internet ombudsman in July as a nod to critics but who has little power to alter legislation.

As Western sanctions multiply over Russia's role in splitting Ukraine, so do rules and restrictions over Europe's fastest growing Internet market, hampering a promising sector in the stuttering economy and forcing young entrepreneurs abroad.

Putin signed a law in July requiring websites used by Russians, from social networks to e-booking services, to store their data on servers in Russia from 2016, within greater reach of local intelligence surveillance.

Since last month, bloggers with more than 3,000 followers must comply with tough rules governing media and since February, authorities have been able to block websites without a court order; the sites of two leading Kremlin critics were among the first blocked, in March, when Moscow seized Crimea from Ukraine.

As pro-Russian rebels took up arms in eastern Ukraine, some Russian news or political sites were also barred. They joined a blacklist of Internet-protocol (IP) addresses set up with the declared aim of child protection but extended late last year to include sites deemed to advocate unsanctioned protests like some of those in 2012 which marred Putin's latest reelection.

Another new rule last month requires Russians to provide identification to use public Wifi hotspots and companies to declare who is using their web networks.

Putin, who alarmed the IT industry in April by calling the Internet "a CIA project", says the measures are needed to fight "extremism" but should not hinder freedom of speech.

DIRECT ACCESS

Many firms still do not understand how to comply or fear the laws may be applied arbitrarily in country where lack of transparency and fair courts are frequent business complaints.

The chief executive of billionaire Alisher Usmanov's Mail.ru Group , which owns two social networks more popular than Facebook in Russia, has warned that freedom from bureaucratic encroachment is vital to home-grown IT companies.

"The course toward excessive regulation," Dmitry Grishin said in comments in April that a Mail.ru Group spokeswoman said still held today, "will lead Russia to lose the Internet as a unique sector able to be a source of growth in our country's new, post-industrial economy."

Many are now heeding Nossik's call to go anonymous online. Six times more Russians are now using Tor, a software to obscure IP addresses, than last year, the firm's data shows.

In response, Russia issued a 3.9-million-rouble ($108,000) tender last month to crack the encryption on Tor - used by activists in countries where the web is censored but also by criminals.

"Soon there won't be anything left to ban," quipped Sergei Plugotarenko, head of the industry trade group Russian Electronic Communications Association (RAEC).

In the wake of revelations of U.S. surveillance activities by former U.S. National Security Agency (NSA) contractor Edward Snowden, who has taken refuge in Russia, many countries are considering placing servers on their own soil.

Russian officials say the aim is to protect Russians' privacy. Andrei Soldatov, whose website Agentura.ru tracks the intelligence agencies, said monitoring was the main goal.

"They are making their life easier by getting direct access to the servers, before the information is encrypted," he said.

Since 1999, telecom operators and hosting providers in Russia have been required to install equipment used by the security services, known as the System for Operative Investigative Activities, or SORM.

Soldatov said new legislation extends that demand to social networks and other online forums, threatening the brand image of tech companies whose users are sensitive about personal privacy.

In California, Google and Twitter declined to comment, whilst Facebook did not respond to requests.

The "blogger law" opens popular bloggers up to prosecution for swearing, libel and "extremism" and fines of up to 500,000 rubles. It also requires everything posted be stored for at least six months on Russian soil.

The new rules spell higher infrastructure costs, according to Andrey Kulikov, an investment manager at Fastlane Ventures, a venture capital fund whose projects have raised about $100 million to invest in online businesses in Russia.

He said it is too early to tell how much impact they will have. "You need a real investment cycle to see the change," Kulikov said. "I would not say everything is catastrophic but the political situation and the regulations will have their effect on the (investment) funds."

VIRTUAL IRON CURTAIN

On Aug. 18, socialite and Kremlin critic Ksenia Sobchak, who has more than 870,000 followers on her micro-blog, posted what she said was a screenshot of a message from Twitter, saying it had received a request for "certain statistics" on her account from Russia's Internet watchdog Roskomnadzor.

She rejoiced that it read, "The information requested ... is not currently maintained by Twitter," but predicted: "...that won't stop them..."

IT entrepreneur and Kremlin critic Leonid Volkov said the aim did not seem to be a Chinese-style clampdown. "It's clear they won't go after everybody but now they have another way to monitor the ones they want to," Volkov said from Luxembourg, where he said he works alongside 20 other Russian programmers.

"They want to create a virtual Iron Curtain to send a signal to people, 'Either you leave, and that's fine by us, or stay here but then we will control everything you do."

That kind of control is some way off as technology firms have pushed back. When a top Twitter executive flew to Moscow to discuss the new laws, Russia's watchdog said it asked him to block a dozen accounts. Twitter said it had not agreed.

Last month, Russian officials went a step further, proposing Apple and software-maker SAP hand over their source code, saying they wanted to protect state institutions against spying. The timing coincided with stepped-up U.S. and European sanctions against Russia and flies in the face of most major technology companies' business practices.

Moscow is not alone in challenging technology firms following Snowden's revelations. It has joined with other countries including China, Iran and India in seeking to take oversight over global Internet infrastructure management away from the US-dominated non-profit group ICANN.

BIG BROTHER?

Critics say the main threat lies at home, not in Washington.

"The real 'Big Brother' is being built before our eyes: A system that knows who wrote what, when, from where and using what device," prominent Putin critic Alexei Navalny said on a blog now blocked in Russia and run by his supporters after he was placed under house arrest, refering to George Orwell's novel on totalitarianism, 1984.

In April, Pavel Durov, the 29-year-old founder of VKontakte, a social media site far more popular in Russia than Facebook, fled the country. He said he was fired and feared punishment for defying a government request to disclose information about activists using his social network site. [ID:nL6N0PI4TH]

"The smart thing to do is to get out of the Russian Internet market," said Nossik, the founder of online news sites including Gazeta.ru and Lenta.ru, platforms for alternative views in a nation where state channels dominate the airwaves.

"Professionals, who were previously proud to work in big Russian IT companies, are moving. I'm talking top managers."

But for all the efforts to clamp down, the Internet remains hard for the state to police as users increasingly turn to virtual private networks which allow them to encrypt traffic on their devices and access blocked sites like Navalny's.

In a dig at the gap between the perceived ambition and less efficient reality of Russia's internet filtering efforts, an activist hacker who briefly took control of the prime minister's Twitter feed last month parodied: "We should think about banning electricity - that'd be more effective."

Many of the new regulations are so vaguely worded or broad, drafted by those who lack savvy, they have confounded technology companies and bred fears of what lawmakers might think up next.

"It's bad for what is probably the only sector of the economy that is growing right now," said Vladimir Kharitonov, head of the Russian Web-publishers Association. "They are slaughtering a hen that lays golden eggs."

In September, Kharitonov's e-books website was blacklisted because it sat on the same IP address as one officials said was promoting illegal drugs. He is appealing to the European Court of Human Rights after losing a battle over the decision at home.

"Everyone is at risk of being blacklisted," he said.

(1 US dollar = 36.8350 Russian ruble)

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"A Printer And A Prayer" - The Three Problems With The Fed "Liquidity Coverage Ratio" Plan

by Tyler Durden

A little over a week ago we wrote that in order to mitigate problems arising from record debt and soaring NPLs, the G-20 had a modest proposal for global banks: more debt. Specifically "in November said leaders will agree "that the world's top banks must issue special bonds to increase the amount of capital which can be tapped in a crisis instead of calling on taxpayers to come to the rescue, industry and G20 officials said." In other words, suddenly the $2.8 trillion in Fed injected excess reserves, split roughly equally between US and European banks, are no longer sufficient, and while regulators are on one hand delaying the implementation of Basel III and its tougher capital rules, on the other they are tactically admitting that whatever "generous" capital buffer banks have on their books right now will not be sufficient when the next crisis strikes."

The proposal for the first time introduced GLACs, or bonds known as "gone concern loss absorption capacity", seen by regulators as essential to stopping the world's 29 biggest lenders from being "too big to fail."

Some of our thoughts at the time: "according to the G-20, instead of having to collapse liabilities to offset that scourge of the New abnormal, namely Non-Performing Loans, banks are hoping to lever up, pun intended, the current scramble for yield and instead beef if up their cash asset, even if it means increasing the liability side of the balance sheet by issuing more debt. Because really all the GLAC do is limit how the banks may use the proceeds from such bond issuance. Then again, these being banks, one can be certain that the moment the GLAC cash is wired in, the funds will be used to ramp risk instead of sitting in a drawer somewhere, awaiting rainy days. Because nobody in a bank is paid for avoiding a crisis, and everyone is paid to generate a return even if it means making the systemic bubble even bigger."

And our summary:

in lieu of being able to actually generate and retain funds from operations, banks will once again scramble to raise epic amounts of debt, only this time, the proceeds will be retained "pinky swear" as a capital buffer, i.e., cash on the books. Cash which nobody makes a single dime in bonus on anywhere in the bank's org chart. Would anyone wish to wager how long before the trillions in GLACs are "mysteriously" found to have funded shanty town developments in Shanghai, to buy the S&P500 at the all time high, and naturally, the purchase of a golden commode or two in various US banks? How could this possibly fail...

And the absolutely brilliant punchline: who do these regulators and "leaders" think will be the purchasers of said debt? Why other systemically important, TBTF banks of course! Which means that, in the by now quite familiar "daisy-chaining" of counterparties and collateral, once one bank fails, its exposure via collateral, repo and certainly, funding of other bank balance sheets, everything will promptly freeze as risk reprices, a la Lehman bonds.

Fast forward to today when, focusing solely on the US, we learned that as part of the domestic "macroprudential" effort to ensure firms don't run out of cash in a crisis, the so-called Liquidity Coverage Ratio, US regulators said banks likely will have to raise an additional $100 billion to satisfy the new requirement, the WSJ reported.

The disclosure is part of the final draft of the so-called Liquidity Coverage Ratio, released by the Fed earlier today, and which was promptly passed on a 5-0 vote Wednesday that will subject big U.S. banks for the first time to so-called "liquidity" requirements. The Federal Deposit Insurance Corp. and the Treasury Department's Office of the Comptroller of the Currency adopted the rules later in the day.

According to the WSJ, the thrust of the proposal remains unchanged: Banks must now maintain enough safe assets to equal their net cash outflows over about a month.

Some of the details: "The 15 largest banks - those with more than $250 billion in assets - will have to hold enough cash, government bonds and other high-quality assets to fund operations for 30 days during a time of market stress. Smaller banks - those with more than $50 billion but less than $250 billion in assets - will have to keep enough to cover 21 days. Banks with less than $50 billion in assets and nonbank financial firms deemed by regulators as posing a potential threat to the system will not be subject to the requirements."

And some more:

Under the final version of the rule, U.S. banks with between $50 billion and $250 billion in assets will be able to calculate their liquidity positions on a monthly basis, rather than every day as proposed in the rule's first draft last fall. Those banks also won't have to start meeting the rule until January 1, 2016, giving them an extra year to comply.

Banks with more than $250 billion in assets will have to comply starting this coming January but will have until July 2015 before they must calculate the liquidity ratio on a daily basis.

...

Staff at the Fed estimated that the rule under consideration Wednesday would require big U.S. banks to raise an additional $100 billion of high-quality liquid assets, for a total of about $2.5 trillion.

Fed officials didn't make changes in response to the industry's concerns about the rule's treatment of municipal debt securities, which weren't classified as safe "high-quality liquid assets" that could count toward a bank's compliance. But Fed Gov. Dan Tarullo said staff would reconsider that point in the future and "develop some criteria for determining which such bonds fall into this category and thus might be considered for inclusion" as a high-quality liquid asset.

The shortfall as illustrated visually by the WSJ:

On the surface, this is all great macroprudential news: forcing banks to hold even more "high quality collateral" is a great idea, to minimize the amount of money taxpayers will have to fork over when the system crashes once again as it certainly will thanks to the unprecedented Fed micromanaging interventions over the past6 years.

There are just three problems.

• First, when it comes to high quality collateral, there just isn't enough, a complaint the TBAC made loud and clear in early 2013 and which served as the basis for our assessment that Tapering will have to take place at least until such time as the US once again is forced to plug massive deficit funding holes, and thus the Fed can monetize copious amounts of debt once more.
• Second, when one considers that the last time the financial system imploded it took not the paltry $700 billion TARP widely trumpeted as the "total" bailout cost, but closer to $14.4 trillion to keep the system from collapsing. As such, $100 billion - if and when the banks' funding mechanisms lock up again in the absence of a perpetual Fed backstop - is nothing but pocket change, even if added to an existing pool of some $2.5 trillion in "high-quality liquid" assets. Furthermore, when the system is locked up in a funding spasm, the last thing any counterparty will bother with is purchasing liquid securities from insolvent competitors at par or even 50 cents on the dollar. In fact, due to the systemic interconnectedness, the only possible buyer of these liquid assets will once again be... you guessed it... the Fed.
• Third, and this is where this whole "macroprudential" scheme crashes under the weight of its own illogic, is when one considers that the source of the funding of any one bank's debt issuance proceeds, are other banks and financial intermediaries, all part of the same group of chain-linked counterparties, which hold on their shoulders over $200 trillion in notional derivatives, and where even one collateral chain breach means net becomes gross and the derivative exposure collapes into the singularity of the next bailout. Basically stated, banks X will be selling debt to bank Y in exchange for cash, thus boosting bank X' capital line item, while depleting bank Y's. And when the moment comes to rescue the liquidity depleted bank Y, what then?

In other words, not only is this latest window dressing too little to make a dent, or that there simply isn't enough of the high quality, liquid collateral needed to prefund a disaster fund, but at the end of the day, all that is happening is a circular pickpocketing where liquidity is simply rotated in a circle without any exogenous funds entering or leaving the banking sector. And as everyone knows, it isn't any one banks that is insolvent: it is the entire banking sector in total, confirmed quickly when one recalls that Hank Paulson "forced" all the banks to accept TARP funding to restore confidence in the US banking system: not a piecemeal bailout.

Which is why we appreciate both the attempt to pull the wool in front of everyone's eyes, and the humor behind it - the sad truth is that all of the above is not only meaningless, but it will likely further concentrate collateral and liquidity shortfalls away into the weakest banks whose failure will just make the TBTFs even bigger and even more systematically important.

What is worst of all, is that this example clearly indicates that when it comes to macroprudential policy, all the Fed really has, is an attempt to reallocate liabilities among the banking sector, in the process further obfuscation each bank's total exposure. As to the most important issue, collateral chains and counterparty exposure should the "weakest link" in said chain fall, the Fed's weapons are the same two it had during the last crisis: a printer and a prayer.

Everything else is still nothing but smoke and mirrors.

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