First Impressions

Editor’s Note
Don Wilson graciously guest-edited the John Lothian Newsletter this week while John is on the mend from back surgery. (By the way, happy birthday JL!) Interested in reading more of Don Wilson’s commentary from the week? Click here to access this week’s newsletters.


Looking Ahead
Don Wilson, CEO, DRW Holdings, this week’s guest editor
Don Wilson
As we close the week, I’ll pick back up on ideas I shared in Monday’s newsletter. Regulation designed to reduce the risk of another financial crisis is being phased in. I would summarize the primary tenets as (1) reduce leverage and risk and (2) ensure that most derivatives are cleared. There is good logic to both thoughts – less leverage is less risky, and futures markets performed flawlessly through the crisis.

Of course it’s never easy to go from well-intentioned concepts to practical implementation, but I will highlight a few concrete effects we have observed on the market. On the deleveraging and de-risking front, it’s very clear that banks take less risk and hold smaller inventories. Because balance sheets are constrained, even near risk-free assets such as U.S. Treasuries trade differently. Off-the-runs have become far less liquid, and swap spreads are negative; in other words, U.S. taxpayers pay more to borrow, while large investors in U.S. debt pay more to transact. The effects can be seen in other markets as well. It’s readily apparent that aggregate risk capital in the marketplace has been significantly reduced. Highly correlated products can have sudden and surprising breakdowns in their relationships. Expect greater dislocations, and more frequent pockets of illiquidity going forward. Is this what was intended?

As far as derivatives moving into clearing houses, we certainly have seen a lot of that. However, some of the rules will actually make it challenging for markets to continue to operate smoothly. Take options portfolios, especially commodities options. Last fall, DRW joined a group of exchanges and firms in sharing our concerns with the Basel Committee about the unintended consequences of the leverage ratio computations. The current method will lead to burdensome capital requirements for clearing members whose customers carry even risk-free portfolios of commodities options, with fewer FCMs willing to clear that business as a result. This, in turn, leads to less diversification and decreased risk capacity – all contrary to well-functioning markets. The end result? Near prohibitive costs to clear in some cases and greater systemic risk – exactly the opposite of what the rules were intended to accomplish.

However, it’s not all doom and gloom. Change – whether well thought out or not – inevitably leads to opportunities for innovation. Let me highlight a few ideas that DRW has been behind, all with the same theme:
Eris Exchange, which through its proprietary interest rate swap futures (traded on Eris and cleared on CME), provides a more efficient alternative to OTC swaps. It also offers Eris credit default swap index futures on ICE, which are starting to trade regularly.
Digital Asset Holdings, which leverages the blockchain and distributed ledgers generally to make the settlement of traditional financial instruments more efficient, thereby enabling market participants to operate in a more capital efficient manner.
Variance swap futures contracts on the SPX and Eurostoxx, listed to the CBOE Futures Exchange and Eurex respectively
-And most recently, an idea for a Libor solution, which we are just starting to discuss with the marketplace.
Of course many new ideas fail, but hopefully some of these – as well as ventures sponsored by others – will be viable solutions for the challenges the markets are facing.

We see how poorly conceived or implemented regulation inadvertently creates adverse consequences. Clearly, today’s adversarial approach to regulation and enforcement is counterproductive. In a rapidly changing industry like ours, regulators must keep pace and engage with market participants to fully understand how the processes, technology and players are evolving and what the impact of new laws and rules will be throughout the ecosystem. Our doors are always open.

Thank you again to John and the JLN team for extending the invitation. I’ve really enjoyed my role as guest editor – maybe I’ll be back for another round. I hope JLN readers benefitted as well; I appreciate the feedback many of you have shared about what I had to say this week. It’s important that we continue to have thoughtful and candid dialogue about the issues shaping our industry.

Quote of the Day

“With this kind of volatility, it’s hard to feel like you can take a break and go chill in some nice restaurant for a while.”

Howard Ward, who oversees $42.7 billion as chief investment officer of growth equities at Gamco Investors Inc., in the story “Why Wall Street’s Iconic Steakhouses Are Empty”

Lead Stories

How Much More Can the Labor Force Grow?
Neil Irwin – NY Times
The immediate headlines out of the latest jobs numbers — that job growth was solid and the unemployment rate unchanged in February — would seem like yawners. But there’s some great news beneath the surface: Americans are returning to the work force in the largest numbers in many years. The American labor force rose by a whopping 555,000 people in February. Over the last three months, that number totals 1.52 million, the highest it has been in 16 years. In other words, this winter a lot more people have been either working or actively looking for work.

Investors pile into US junk bond funds
Eric Platt – Financial Times
Investors piled into US junk bond funds at the fastest pace on record as a relief rally in global equity and fixed income markets coaxed fresh money off the sidelines. US funds invested in high yield debt counted $5bn of inflows in the week to March 2, the greatest seven-day haul since record keeping began in 1992, according to fund flows tracked by Lipper.

Here’s Why China Laying Off 1.8 Million Workers Is Actually Good News
Winter Nie – Fortune
When the bubble burst on Shanghai’s Stock Exchange last summer, China’s government was criticized for a lack of transparency. Not knowing what to expect next, thousands of shareholders bailed out, and for a while, it looked as though the renminbi (RMB) might teeter on the edge of free fall. With the Chinese economy now going through a long overdue deceleration after years of unprecedented growth, Beijing appears determined not to make the same mistake twice. The announcement of dramatic cuts in steel and coal production on Monday took advantage of a state visit by U.S. Treasury Secretary Jack Lew to guarantee widespread news coverage.

Rainmakers Turn Caretakers
Lionel Laurent – Bloomberg
Earnings season for Europe’s big banks is over — and the outlook is dismal. After posting losses for 2015, the CEOs of Deutsche Bank, Barclays and Credit Suisse asked investors for patience as they slashed dividends to fund long-term revamps of their businesses. Frustrated shareholders feel they’ve already paid the cost of eight years of restructuring — and got nothing in return. Their response has been to send already battered bank stocks even lower.

Goldman, BofA Dismiss Traders After Getting Taste of 2016 Markets
Dakin Campbell, Laura J Keller and Hugh Son – Bloomberg
Goldman Sachs Group Inc. and Bank of America Corp., two of Wall Street’s biggest investment banks, plan to lean on their periodic culls of low performers this year to rein in costs as a market rout pressures returns.

Does the United States have a productivity slowdown or a measurement problem?
David M. Byrne, John G. Fernald and Marshall B. Reinsdorf – Brookings
After 2004, measured growth in labor productivity and total-factor productivity (TFP) slowed. We find little evidence that the slowdown arises from growing mismeasurement of the gains from innovation in IT-related goods and services. First, mismeasurement of IT hardware is significant prior to the slowdown. Because the domestic production of these products has fallen, the quantitative effect on productivity was larger in the 1995-2004 period than since, despite mismeasurement worsening for some types of IT—so our adjustments make the slowdown in labor productivity worse

Silicon Valley Has Not Saved Us From a Productivity Slowdown
Tyler Cowen – NY Times
American middle class wages haven’t been rising as rapidly as they once were, and a slowdown in productivity growth is probably an important cause.
In mature economies, higher productivity typically is required for sustained increases in living standards, but the productivity numbers in the United States have been mediocre.

Pension fears cloud US municipal debt market
Ben McLannahan – Financial Times
US investors know in a crunch politicians favour voters and pensioners over bondholders
On the Boardwalk in Atlantic City, just across from the hot dog stands and thrill rides on the old Steel Pier, sits the Trump Taj Mahal. Opened in 1990, it went bust a year later. Two other casinos carrying the name of Donald Trump went the same way over the following years. The Taj — which failed again in 2014 — was sold last week to Carl Icahn after emerging from bankruptcy protection.

U.S. Government Bonds Post Biggest Weekly Selloff Since November
Min Zeng – WSJ
Fresh signs of a robust U.S. labor market drove investors to sell U.S. government debt Friday, sending the yield on the benchmark 10-year note to a one-month high. The yield on the benchmark 10-year Treasury note settled at 1.883%, compared with 1.830% Thursday. Bond yields rise when prices fall.

Australia watchdog accuses ANZ of rate rigging
Jamie Smyth and Jennifer Thompson – Financial Times
Australia’s corporate regulator is suing ANZ Banking Group for alleged manipulation of the country’s benchmark interbank borrowing rate, in the latest in a series of global interest rate rigging scandals. The Australian Securities and Investments Commission on Friday accused ANZ of engaging in “unconscionable conduct and market manipulation” to boost its profits in a test case that is likely to determine whether other big banks face similar legal actions.

Central Banks

European Central Bank Faces Questions Over Which Bonds to Buy
Tom Fairless – WSJ
The European Central Bank faces a dilemma as it considers boosting its roughly EUR1.5 trillion ($1.6 trillion) bond-purchase program next week: how to ensure it has enough bonds to buy without sparking legal tussles. The ECB is now buying about EUR60 billion a month of mainly eurozone government bonds, based on self-imposed rules that limit how much it can acquire from individual governments. But those rules mean the supply—particularly of low-risk German bonds—will be exhausted before the program ends next March, and sooner, if it is expanded next week, economists say.

Monetary Policy: Europe Evaluates its Options
Patrick Artus – FTSE Global Markets
Europe is showing no signs of growth, outlook for investment remains subdued, with poor global trade resulting in weak exports – while wages continue to be dampened by low inflation. This suggests that the European Central Bank (ECB) will continue its expansionary monetary policy throughout 2016, with a likehood that this will also carry through to the first half of 2017. However, the pressing question is whether the ECB will be able to scale down its monetary policy in the medium term, or if their expansionary programme is irreversible. To assess this, we evaluate three possible scenarios.

Fed to Unveil New Rules Aimed at Corralling Banks’ Risk
Donna Borak and Ryan Tracy – WSJ
Policy makers are poised to unveil a new plan Friday that seeks to restrain how quickly risk can spread among the country’s biggest banks. The Federal Reserve’s revised proposal will be the central bank’s latest step to minimize the systemic risk posed by the biggest banks—not based on size, but on interconnections with other large firms—by limiting how much exposure institutions may have to each other and to their counterparties. Despite its potential significance to stem contagion in financial markets, the rule—known as the single counterparty credit limit—has spent years on the back burner. Until now, regulators had been focused largely on other high-profile rules tied to capital, liquidity and other curbs on risk-taking.

Too eagerly anticipated: The impact of the extension of ECB QE on asset prices
Menno Middeldorp and Oliver Wood – Bank Underground
When the ECB announced an extension of its asset purchase programme on December 3 2015, the euro appreciated, bond yields rose and equity prices fell. This does not mean that the extension tightened monetary policy, but merely that it was smaller than what markets had priced in. In order to calculate the full impact of the programme on asset prices, we need to measure both the anticipation effect and announcement effect and add the two up. Our analysis suggests that the announcement effect undid about half of the anticipation effect, and so the extension of asset purchases still pushed down yields, supported equity valuations and depreciated the euro. However, compared to the initial programme, its impact on asset prices was smaller.

Debt ‘explosion’ awaits unless policymakers defuse demographic timebomb, warns IMF chief
Szu Ping Chan – The Telegraph
People will have to work longer and pay more taxes as ageing populations put a strain on government finances, according to the managing director of the International Monetary Fund.
Christine Lagarde said the challenges facing governments this century required a policy overhaul.

The Fed isn’t off the hook yet
Matt Phillips – Quartz
It’s true. The February jobs report was good. More jobs (242,000) were created than were expected (195,000). The unemployment rate remained at 4.9%, its second straight month below the 5% level that many see as “full employment” or the point at which the Fed should start raising interest rates in order to head off an inflationary spiral. Many are wrong. How do we know? Precisely because the unemployment remained stable, despite the creation of more than 242,000 new positions. In other words, the supply of the labor market is rising. People are coming back to work.

King’s financial pawnshop for all seasons
Financial Times
Mervyn King wants to make the job of a central banker more interesting. After what he went through as governor of the Bank of England during the crisis, you might think it was interesting enough already but, since retiring, he has thought about why it happened and why there’s another one coming.


ForexClear pioneer steps down amid fall-out
Farah Khalique – Euromoney Magazine
Gavin Wells, the pioneer of LCH.Clearnet’s ForexClear offering, and his right-hand man Basu Choudhury have stepped down amid talk of a fall-out with the clearing house over returns, bringing into question the future direction of ForexClear. The poster boy for ForexClear, Wells was in charge of building and leading LCH.Clearnet’s clearing services for foreign-exchange products, in anticipation of mandated clearing from regulators. Choudhury was hired in 2011 as a director and head of product at ForexClear, according to his LinkedIn profile.

From Schengen to ‘Brexit,’ Risks to the Euro Are Stacking Up
Lucy Meakin – Bloomberg
It’s not only European Central Bank stimulus that has the potential to hurt the euro. From the possibility that Britain might leave the European Union and the impact of refugees flooding the region, to concerns over the economic outlook and political turmoil in Ireland as well as Spain, the euro is facing a slew of hazards. Set alongside economists’ expectations for lower interest rates and more asset purchases from the ECB, investors are wondering how low it can go.

Dollar Defying Forecasts Stumps Hundreds of Companies That Hedge
Thomas Black and Lananh Nguyen – Bloomberg
With hotels in 87 countries, Marriott International Inc. is finding it harder to protect itself from currency swings as exchange rates in the $5.3-trillion-a-day market defy expectations. The chain locked in its 2016 currency hedges about four months ago, anticipating the dollar would extend a three-year winning streak. Instead, the greenback has had a mixed performance, slumping against the euro and yen this year amid turmoil in global markets. That’s a problem because the cost of the hedges would be wasted if the dollar weakens.

Why the Dollar’s Weakness May Not Last
Ben Eisen – WSJ
The U.S. market has had it good in recent weeks: Data has been largely positive, while the U.S. dollar has remained weaker against its major peers. That may not last. The dollar tends to strengthen when the U.S. economic outlook looks good relative to other countries and the Federal Reserve is seen as being able to adopt less accommodative monetary policies. Yet after a sharp rise since mid-2014, the greenback has slipped in recent weeks. It’s down 1.6% so far this year. That comes even as the Fed’s monetary policies move in the opposite direction of its major peers.

Global Pressure Gives Japan Few Options to Weaken Yen
Takashi Nakamichi – WSJ
What do Donald Trump, Hillary Clinton and the Dutch finance minister have in common?
Answer: They have all recently expressed concern about the way Japan is handling the yen—much to the consternation of policy makers in Tokyo, as they struggle to revive the country’s economy with ever-looser monetary policy.

The New Cash Hoarders
Are Japan and Switzerland havens for terrorists and drug lords? High-denomination bills are in high demand in both places, a trend that some politicians claim is a sign of nefarious behavior. Yet the two countries boast some of the lowest crime rates in the world. The cash hoarders are ordinary citizens responding rationally to monetary policy.

China should avoid FX intervention, capital controls: ex-IMF official
China should not resort to capital controls or currency intervention to counter yuan depreciation, as capital outflows are merely a symptom of structural problems that need to be addressed as its economy slows, a former senior IMF official said on Friday.

Ruble Shockwaves Mean Longer Wait Until Disinflation Sets In
Anna Andrianova – Bloomberg
Don’t expect the good optics of Russian disinflation to last long. While price growth eased in February to the slowest since September 2014, the shockwaves of the ruble’s collapse earlier this year are set to catch up with the six-month deceleration. UniCredit SpA, Promsvyazbank PJSC and Gazprombank OJSC say inflation will end the second quarter in double digits before a deeper slowdown sets in. The annual consumer-price index slipped to 8.1 percent from 9.8 percent in January, the Federal Statistics Service in Moscow said Friday. The median of 15 estimates in a Bloomberg survey was for a drop to 8.4 percent.

Angola’s currency is the most overvalued in Africa, based on the “KFC Index”
Lily Kuo – Quartz
Angola, Africa’s second largest oil producer, is home to the most overvalued currency on the continent. Angola’s kwanza is 72% overvalued against the dollar, according to a comparison of the cost of a bucket of fried chicken from the fast food retailer KFC in 16 African countries in February.

Pound Falls Versus Euro, Paring Biggest Weekly Gain in 4 Months
Lukanyo Mnyanda – Bloomberg
The pound dropped against the euro, paring its biggest weekly gain in four months, as waning concern about the risk of the U.K. leaving the European Union coincided with signs of economic weakness. Sterling pared its decline versus the dollar after the U.S. reported that wages unexpectedly declined in February, data that may diminish the chances of the Federal Reserve increasing interest rates any time soon. U.K. manufacturing data this week signaled the domestic economy is losing momentum, reducing the chances of the Bank of England raising its own benchmark rate. The euro was also supported as traders assess the chances of additional stimulus from the European Central Bank next week.

Indexes & Index Products

In Fledgling Exchange-Traded Fund, Striking a Blow for Women
Paul Sullivan – NY Times
State Street Global Advisors will introduce its 159th exchange-traded fund on Tuesday, the SPDR Gender Diversity Index E.T.F. Fortunately, the fund’s ticker symbol is catchier: SHE. The fund’s goal is to achieve market-rate returns by investing in United States companies that “are leaders in advancing women through gender diversity on their boards of directors and in management.” It will track an index of 125 to 150 stocks that have been culled from the Russell 1000 index and have scored high on a scale of gender metrics.

Me Active, You Index
John Rekenthaler – Morningstar
Richard Thaler, the 2015 president of the American Economic Association, agrees with Nobel laureate Eugene Fama that retail investors are best off owning index funds. Warren Buffett gives similar advice, as does David Swensen, Yale’s chief investment officer. Harvard professor Andre Perold serves as a director for the bastion of indexing, Vanguard. Yet, while advocating indexing, four of those five are unquestionably active investment managers. Thaler is a principal of Fuller & Thaler Asset Management, which runs institutional monies in addition to subadvising on a mutual fund. Buffett, of course, runs Berkshire Hathaway’s (BRK.B) stock portfolio. For their part, Swensen and Perold both allocate their assets actively (Swensen for Yale’s endowment fund, Perold for his advisory firm’s clients), frequently by using actively managed funds.

Value ETF Style Back in the Vogue
Tom Lydon – ETF Trends
After underperforming the growth style in recent years during the bull market rally, value stocks and related exchange traded funds are beginning to pick up their pace.
“At the end of the day, these are styles,” Ben Johnson, director of global ETF research for Morningstar, said. “And like any style, they will go into and out of vogue. Value investors today are feeling a bit like they are showing up to fashion week wearing bell bottoms.”

How To Play The Choppy Market With Cheap Smart Beta ETFs
Seeking Alpha
The global stock market has been shaky, with a series of woes related to China and oil price. While the number of headwinds is raising questions on the health of the global economy, domestic growth seems to be on track with a spate of encouraging data lately.

News analysis: Indices await A-share overhaul
FT Adviser
The whipsaw moves in Chinese equity markets seen over the past 12 months may have made investors more wary of plans to include the country’s A-shares in emerging market indices. But moves remain afoot.


Gold Demand Trips Up BlackRock as ETF Halts Share Creation
Sabrina Wilmer – Bloomberg
BlackRock Inc. on Friday temporarily stopped issuing new shares in its $7.7 billion iShares Gold Trust, as surging interest in the precious metal caught the world’s largest money manager off guard. Investors had piled into the fund so fast that BlackRock didn’t register in time with the U.S. Securities and Exchange Commission to issue more shares. The suspension means that the share price of the fund may deviate from the price of its underlying assets — the physical gold — until issuance resumes, probably within two or three business days, according to a person familiar with the matter.

Gold, silver volatility to lead to mayhem in 2016 commodities
James Cordier – MarketWatch
For commodity option sellers, the latter part of 2015 presented some solid option-writing opportunities. But with the exception of a few segments in the oil market, volatility was low across most sectors. Selling options in this environment can still produce firm results. But it involves a little more precision, and a little more timing. It’s like tacking your sailboat against the wind. You can still get to your destination. It just takes a bit more effort.


Why Wall Street’s Iconic Steakhouses Are Empty
Steps from the New York Stock Exchange, only a handful of tables are occupied at Bobby Van’s Steakhouse. Across the street, Reserve Cut has scores of empty seats. A few blocks away at Delmonico’s, one of the few diners is the restaurant’s own hostess, seated at the end of a half-empty bar.

Quants don’t eat steak
The Reformed Broker
Allow me to unravel the mystery of why the Wall Street steakhouses are all empty, with the S&P 500 sitting within 5% of all-time highs.

How to say no to helping other people without seeming like a jerk
Adam Grant – Quartz
If you want something done, ask a busy person. The old saying rings true, but it also spells doom for that busy person. When you develop a reputation for being responsive and generous, an ever-expanding mountain of requests will come your way. This may be why Warren Buffett says: “The difference between successful people and very successful people is that very successful people say ‘no’ to almost everything.”

Intel’s Pentium Bug Fix Is Proposed as Solution for Dark Pools
John Detrixhe – Bloomberg
Modern markets are driven by software algorithms that humans struggle to debug. To stamp out problems, financial regulators should use the same technique Intel Corp. has deployed following an infamous chip crisis in the 1990s, according to a London-based technology firm. Rather than only providing pages of text describing their trading systems, dark-pool operators should give regulators mathematical models that show precisely how they work, Aesthetic Integration Ltd. told the U.S. Securities and Exchange Commission in a letter last week. The code could then be examined with formal verification.

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