Regulatory Agencies to Review Volcker Rule Provisions for Foreign Funds

Five federal financial regulatory agencies will review the treatment of certain funds under section 13 of the Bank Holding Company Act (“BHCA”), as added by the Volcker Rule.

According to a joint statement, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the SEC, and the CFTC (collectively, the “agencies”) will undertake a coordinated review of how the Volcker Rule (codified at BHCA Section 13) applies to certain foreign funds that are excluded from the definition of “covered funds.” The purpose of the review is to examine “possible unintended consequences” and impacts of the Volcker Rule.

The agencies stated that market participants are concerned about potential competitive disadvantages that could arise as a result of certain foreign funds being subjected to the Volcker Rule’s requirements due to their affiliations with a foreign banking entity, while other foreign funds remain exempt from the Volcker Rule’s requirements because they are not affiliated with a banking entity. Such foreign funds often fall outside (or are excluded from) the Volcker Rule’s definition of “covered fund,” and thus foreign banking organizations are free to invest in or sponsor such funds without violating the Volcker Rule. Nonetheless, the act of sponsoring or investing in the so-called “foreign excluded funds” can create certain problems for the funds themselves.

A foreign banking entity’s investment in or sponsorship of such a foreign excluded fund can cause the fund to be viewed as “affiliated” with the foreign banking entity. If deemed to be affiliated, foreign excluded funds are themselves “banking entities” and the funds themselves must comply with the Volcker Rule’s requirements – in particular, such funds are prohibited from engaging in proprietary trading or investing in other covered funds, absent an exception in the Volcker Rule. In addition, such funds must maintain a Volcker compliance program.

In this regard, the agencies noted that the Volcker Rule incorporates the BHCA’s existing concept of “affiliation.” For example, a foreign excluded fund would be “affiliated” with a foreign banking entity if the foreign banking entity were the general partner of the foreign excluded fund, or if the foreign banking entity were to own more than 25% of the voting shares of the fund.

The agencies also are not willing to simply exempt all foreign excluded funds from the scope of the Volcker Rule. There is no clear definition of what is a “foreign excluded fund” – other than an entity that isn’t a Volcker Rule regulated “covered fund.” The agencies expressed concern that exempting all foreign excluded funds from the “banking entity” definition could enable foreign banking organizations to use structures self-described as foreign excluded funds to engage in proprietary trading or covered fund investing in a manner that the foreign banking organization could not do so directly.

The agencies stated that until July 21, 2018, the agencies will not treat as a “banking entity” any foreign excluded fund that meets the agencies’ definition of a “qualified foreign excluded fund.” A “qualified foreign excluded fund” is defined as an entity that:

(1) Is organized or established outside the United States and the ownership interests of which are offered and sold solely outside the United States;

(2) Would be a covered fund were the entity organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;

(3) Would not otherwise be a banking entity except by virtue of the foreign banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, the entity;

(4) Is established and operated as part of a bona fide asset management business; and

(5) Is not operated in a manner that enables the foreign banking entity to evade the requirements of the Volcker Rule or its implementing regulations.

The agencies further noted that ultimately any relief may require Congressional action to amend the Volcker Rule itself.

CFTC Acting Chair Giancarlo Appoints Chief Innovation Officer

CFTC Acting Chair Christopher J. Giancarlo named Daniel Gorfine as Chief Innovation Officer and Director of the LabCFTC initiative (see previous coverage). Mr. Gorfine will be responsible for coordinating with U.S. regulators and international regulatory bodies as the CFTC develops digital regulatory frameworks and strives to “promote market-enhancing FinTech innovation and incorporate emerging regulatory technologies.”
Most recently, Mr. Gorfine served as director of financial markets policy and legal counsel at the Milken Institute think tank.

Foreign Exchange Working Group Outlines Standards for Forex Market Participants

A group of central bank representatives and private sector market participants known as the Foreign Exchange Working Group (“FXWG”) released a new version of the “FX Global Code,” a set of conduct standards and principles for foreign exchange (“forex”) market participants. The FXWG was formulated in 2015 in order to “promote a robust, fair, liquid, open, and appropriately transparent market.”

The new version of the FX Global Code expands the topics covered by Phase One of the Code (ethics, information sharing, certain aspects of trade execution, and trade confirmation and settlement) published on May 26, 2016 (see Cadwalader Clients & Friends Memorandum, June 1, 2016). The new version includes: aspects of execution on e-trading and platforms, prime brokerage, governance, and risk management and compliance. Other important topics covered in the new version of the FX Global Code include “pre-hedging” and last-look practices.

As a whole, the FX Global Code covers six broad areas:

  • ethics;
  • governance;
  • execution;
  • information sharing and confidentiality;
  • risk management and compliance; and
  • transaction confirmation and settlement.

Lofchie Comment: The appropriate standards of conduct in the forex market have long been ambiguous, given (1) the absence (until Dodd-Frank) of much of a statutory/regulatory framework, (2) the fact that it is largely a principal market, (3) the limited involvement of lawyers and compliance personnel who might have served as “gatekeepers,” and (4) limited trade reporting information that might have served as a check on misconduct. That period of ambiguity is ending. While the FX Global Code may not have the force of law, regulators and private litigants are likely to point to it as establishing the required standard of conduct.

Many of the principles established in the FX Global Code are basic; e.g., one should strive to do the right thing, firms should manage risk appropriately, and trade disputes should be promptly resolved. Other standards, particularly those related to executing and information walls, will need to be carefully considered as to how they are implemented. Firms should review (or establish) compliance procedures for their FX desks and should compare those procedures to those governing other similar but perhaps more regulated markets.

Sargen: Time to Consider Europe

Highlights

  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.


Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100


Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

Report on Repo Market Financing Raises Concerns

The Bank for International Settlements (“BIS”) published a Report that found that changes in the availability and cost of repurchase agreement (“repo”) financing are affecting the ability of repo markets to support the financial system. The Report was prepared by a study group organized by the BIS Committee on the Global Financial System (“CGFS”) that included staff members from international regulatory agencies, the Board of Governors of the Federal Reserve System and the New York Fed.

The study group examined repo transactions backed by government bonds and concluded that banks in some jurisdictions appear to be less willing to undertake repo market intermediation than they were before the crisis. Key “drivers” behind these changes include “exceptionally accommodative monetary policy” and regulatory changes that have made intermediation more costly. However, the study group cautioned that it would be premature to establish correlations between policy changes and changes in the market given “differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition.”

To improve repo market functioning, the study group recommended that a series of temporary measures be implemented, including steps to reduce the “scarcity of certain collateral.”

Lofchie Comment: It seems regulators are beginning to acknowledge that new regulations may have had some negative effects on the financial markets, financial market participants, investors and the economy. Seee.g.Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker RuleComptroller Reviews Regulatory Environment for Community Banks and Mutual Associations. This is a welcome development. It is the start of a conversation about the fact that some rules do more harm than good and that not every examination of a rule has to be a partisan or political event.

Sargen on China – U.S. Tensions…Diminish for Now

Highlights

  • Notwithstanding adverse political news at home, the Trump rally has continued amid favorable economic news and investor optimism about pending corporate and personal income tax cuts.  Diminished tensions between the Trump Administration and China have also lessened the risk of a trade war.
  • The key event was President Trump’s reaffirmation of the “One China” policy to President Xi in a telephone exchange earlier this month.  At the same time, Defense Secretary Mattis talked about the need for a diplomatic rather than military solution to the dispute in the South China Sea, which the Foreign Ministry in China welcomed.
  • With Steve Mnuchin assuming the helm as Treasury Secretary, market participants are awaiting the stance the Treasury will take on whether to declare China a “currency manipulator.”  Press reports suggest the Trump Administration may change tactics, so that China is not singled out.
  • The bottom line: The risk of an escalation in tensions between the U.S. and China has lessened, and it appears moderates in the Trump Administration are calling the shots.   Nonetheless, circumstances could change if the dispute in the South China Sea heats up or if China’s trade surplus with the U.S. were to increase.

President Trump Moderates His Stance on China

At a time when the Trump Administration has been engulfed with a series of adverse political developments, market participants appear oblivious to them, and the so-called Trump rally lives on.  The principal reasons are that news on the economic front has been favorable, consumer and business confidence readings remain high, and investors are focused on the prospect for significant cuts in both corporate and personal tax rates.

In addition, a potential negative factor –namely, the prospect for a trade war between the U.S. and China – has also diminished recently.  The key development was a sudden reversal in President Trump’s stance toward China.  Throughout the presidential campaign, Mr. Trump took a hard line on China, claiming that its trade policies were unfair, and on several occasions he called for imposing tariffs of 35% on Chinese imports into the U.S.  Immediately after assuming office, President Trump upped the ante by congratulating the leader of Taiwan and by indicating he was open to reviewing the One China policy that China’s leaders regard as non-negotiable.

During the past month, however, the Trump Administration has softened its stance considerably.  In a telephone conversation with China’s leader, Xi Jinping, the President retreated from his earlier statement, and he indicated the White House had agreed to honor the One China policy “at the request of President Xi.”

The timing of the call was significant, coming just before President Trump met with Japanese Prime Minister Shinzo Abe to discuss the commitment of the U.S. to East Asia. It also coincided with a trip to Japan and South Korea by Defense Secretary Mattis, during which he talked of the need for a diplomatic rather than military solution to the dispute over islands in the South China Sea. The Foreign Ministry in Beijing welcomed the remarks and the Chinese press called them a “mind-soothing pill” that “dispersed the clouds of war.”1

Looking behind the scenes, these developments suggest that moderates in the Administration such as Secretary of State Rex Tillerson, Defense Secretary James Mattis and National Economic Council Director Gary Cohn are calling shots on China policy for the time being.  This is reassuring to those who worried that Peter Navarro, Wilbur Ross, and Robert Lightziger, who have a more protectionist bent, could be in charge of trade policy.


Is China a Currency Manipulator?

With Steven Mnuchin now confirmed as Treasury Secretary, market participants will now be watching to see whether the Treasury declares China to be a “currency manipulator,” as Mr. Trump suggested during the presidential campaign.  Since 2015, the criteria that the Treasury has used for making such a designation has been three-fold: (i) the country has a large current account surplus, defined to be in excess of 3% of GDP; (ii) it has a large bilateral trade surplus with the U.S.; and (iii) it intervenes in the currency markets to weaken its currency versus the U.S. dollar.

Based on these criteria, China meets only one condition – namely, it has a large bilateral surplus with the U.S.  Its overall current account surplus, by comparison, has fallen steadily over the past decade, and is currently less than 3% of GDP.  And while the Chinese authorities intervene regularly in the foreign exchange markets, since 2014 they have been primarily sellers of U.S. dollars.  The reason: China has experienced massive capital flight that far exceeds its currency account surplus, and the authorities have been trying to limit the depreciation of the RMB versus the dollar.

Weighing these considerations, the Treasury in the past has refrained from declaring China to be a currency manipulator.  If it were to do so now, the rationale would be political rather than economic.  Even then, it is unlikely the Trump Administration would want to escalate the issue at this time when it already has moderated its stance.

A recent Wall Street Journal article (February 14, 2017) stated that the White House is exploring a new tactic to discourage China from undervaluing its currency.  Under the plan the Commerce Secretary would designate the practice of currency manipulation as an unfair subsidy, without singling out China, and U.S. companies could then bring complaints to the Commerce Department.  While this tactic is in keeping with the stance adopted by previous administrations, Chinese officials reportedly are bracing for an unprecedented number of trade disputes, and they are considering possible retaliatory actions.


Avoiding a Full Scale Trade War

Both the United States and China for the time being are seeking to avoid a full scale trade war that would produce a “lose-lose” situation.  Investors, nonetheless, must consider the possibility of such an outcome in the future, especially if China’s bilateral trade surplus with the U.S. were to widen, while the RMB would weaken further against the dollar.

The latter outcome remains a distinct possibility for two reasons.  First, U.S. import demand is likely to surge if the U.S. economy continues to gain traction, and imports from China would in turn be boosted. Second, a stronger economy is likely to bring the Fed into play, and a widening in interest differentials between the U.S. and China would place added pressure on the RMB. In these circumstances, the Trump Administration could very well come down on the side of those who contend China is manipulating its currency, even if the Chinese authorities intervene to limit the depreciation of the RMB.

In these circumstances, markets are likely to focus on whether any sanctions imposed by the U.S. are targeted to specific items or are broadly based and severe. In the former case, markets would likely take the news in stride, as there are numerous instances in which the U.S. has imposed sanctions on select items.  However, if the Trump Administration were to up the ante by imposing broad-based sanctions – including high tariffs across a wide range of goods – markets would likely sell off, as investors would anticipate retaliation by the Chinese authorities and other countries that are affected.

Our assessment is the risk of a full scale trade war has lessened for the time being.  However, political developments such as a widening in the dispute over islands in the South China Sea or adverse developments in the U.S. could result in an escalation of trade tensions at some point.  In this respect, the risk of a trade war cannot be ruled out entirely.


1See Goldman Sachs report “Top of Mind,” February 6, 2007.

Sargen on Trump’s Trade Policy

Highlights

  • During the election campaign, Donald Trump ran for office on restoring lost jobs in manufacturing by renegotiating trade deals and imposing tariffs on imports from countries that are deemed to hurt American workers. Now that he is President, market participants are focusing on what he will do.
  • One of his first decisions will be his stance on a “border adjustment tax” (BAT), a key provision in the House Republican tax bill that is intended to incent U.S. companies to produce at home rather than abroad.  In an interview last week, Mr. Trump indicated he favors a simpler approach of imposing stiff duties on countries that disadvantage U.S. workers and U.S. based companies that shift production abroad.[1]
  • A key problem with the President’s trade policy, however, is that it runs counter to market forces.  Because the dollar’s value is mainly driven by capital flows, stronger growth and rising U.S. interest rates threaten to propel it higher.  Also, the President’s fiscal stance of lowering tax rates but not broadening the tax base would likely balloon both the budget and trade deficits.
  • The bottom line: President Trump’s efforts to reduce the trade deficit and restore lost jobs in manufacturing are likely to fail.  Moreover, his policy of raising tariffs is bound to invite retaliation in which all parties would lose.

President Trump’s Views on Trade and the Dollar

Throughout the Presidential campaign, Donald Trump articulated a stance on international trade that reflects his long-standing views.  At the core, his world view is mercantilist: International trade is a zero sum game with winners and losers, and the losers are countries that run trade deficits.

While Mr. Trump’s views on trade are at odds with the post-war order, in which free trade was seen as a means for promoting world growth, he was by no means the only candidate to abandon free trade principles.  Indeed, in the wake of the 2008 financial crisis, for the first time in modern history no presidential candidate ran on a pro free-trade platform.  Where Mr. Trump stood apart from other candidates was his call to renegotiate existing trade arrangements and his threats to impose heavy duties on countries and U.S. businesses that are deemed to pursue policies that harm U.S. workers.

Now that he is president, Mr. Trump has announced the United States will withdraw the U.S. from the Trans-Pacific partnership, and he is planning to meet with the leaders from Mexico and Canada to discuss NAFTA.  One of the first legislative decisions Mr. Trump will make is his stance on the issue of a border adjustment tax (BAT), which is a key provision in the House Republican tax bill. The BAT is called a “destination based cash flow tax,” because it does not include export revenues in corporate taxes, while it excludes imported items from costs. The Republican leaders in the House favor the idea because: (i) it incents businesses to produce at home rather than abroad; and (ii) it is estimated to raise $1 billion in tax revenues over a decade that would help fund the proposed cut in the corporate tax rate to 20% from 35%.

The BAT concept is very controversial, because it is untested and critics contend it could be disruptive to businesses with global supply chains.  Proponents contend this is not the case, because they claim there would be offsetting movements in the dollar.  For example, if U.S. exporters were able to reduce the price of a product sold abroad, it would increase demand for dollars and boost the value of the dollar.  Accordingly, some economists estimate that if the corporate tax rate were lowered to 20% the dollar would likely appreciate by about that amount, although that issue is subject to debate.

In a recent Wall Street Journal interview, Mr. Trump stated the BAT proposal was too complex, and he favors a simpler approach of raising tariffs on imported goods including those from overseas’ operations of U.S. based companies.  He also expressed concern that the dollar was “too strong” in part because China holds down its currency, the yuan: “The yuan is ‘dropping like a rock,’ Mr. Trump said, dismissing recent Chinese actions to support it as being done simply ‘because they don’t want us to get angry.”

It remains to be seen what the final legislative outcome will be.  Some commentators believe the House Republican leaders will continue to press for a BAT; however, to gain the President’s approval, they will have to compromise on provisions of the pending tax bill.  As discussed below, the House Republican tax bill is intended to be revenue-neutral, whereas the proposal that Mr. Trump favors would increase the budget deficit significantly.


An Inconsistent Trade Policy: Lessons from the 1980s

Whatever the outcome, President Trump’s approach to trade and the dollar is flawed, in my opinion, because it ignores the impact of market forces on the dollar and the trade balance.  In this regard, there are several valuable lessons from the experience of the Reagan presidency in the 1980s that apply today.

One of the main lessons is that the dollar’s value is determined primarily by international capital flows, rather than international trade flows.  During the Reagan era, for example, the combination of a resurgent U.S. economy and high U.S. interest rates relative to those abroad attracted massive capital inflows that sent both the dollar and the U.S. trade deficit to then record levels.

U.S. interest rates today, of course, are considerably lower than in the 1980s; nonetheless, they are still well above those abroad. The dollar currently is at a 14-year high on a trade-weighted basis, and it has surged since the presidential election.  Should the U.S. economy accelerate, as President Trump is seeking, the Fed is likely to tighten monetary policy further, which would drive the dollar even higher.  Similarly, if China continues to experience capital flight, the Chinese yuan is likely to depreciate further, despite efforts of the authorities to limit the decline.

A second lesson is the trade imbalance is likely to widen considerably if the budget deficit increases materially, as was the case in the 1980s, when the U.S. ran “twin deficits” (see chart). The intuition is that increased government spending on the military and infrastructure is likely to boost imports but do little to increase exports. More fundamentally, the national income identity holds where the imbalance on trade is equal to the sum of the budget imbalance and the saving-investment imbalance in the private sector. If the latter is unchanged, the trade deficit increases directly with the change in the budget deficit.

U.S. Budget and Trade Imbalances as a Percent of GDP


Source: Bureau of Economic Analysis, Dept. of Commerce.

 

In this regard, a lot hinges on the type of tax legislation that is forthcoming. Specifically, there is an important difference between the House Republican tax bill, which is designed to be deficit-neutral, with the plan that Mr. Trump campaigned on, which independent research institutions estimate would add about $6 trillion to federal debt outstanding over the next ten years. The primary reasons are the Trump plan calls for deeper cuts in the corporate tax rate to 15% versus 20% in the pending House bill, and the Trump plan does not seek to broaden the tax base, whereas the House bill does.

The bottom line, therefore, is that if President Trump’s efforts to boost economic growth via tax cuts and increased government spending unfold, the trade deficit is likely to expand considerably.


The Worst Outcome: A Needless Trade War

While President Trump’s trade policies are unlikely to produce the results he is seeking, the worst outcome for financial markets would arise if the policies culminated in an unnecessary trade war with China, Mexico, and other countries.

It is hard to tell at this juncture whether President Trump’s call for duties in the neighborhood of 35% on imported items from certain countries is a negotiating ploy to extract a better deal, or whether he is serious and will follow through.  Based on his selection of Cabinet appointees to handle trade matters, however, this threat should not be taken lightly.  They include Peter Navarro, a China critic to head the new National Trade Council, Wilbur Ross as Secretary of Commerce, and Robert Lighthizer, a lawyer who represents industries seeking government protection via trade barriers.  At the same time, President Trump appears determined to declare China a currency manipulator, even though the Chinese Government has spent one trillion dollars in foreign exchange reserves in an attempt to limit the yuan’s depreciation against the dollar.

Should the Administration pursue such a course of action, it would inevitably invite retaliation, either in terms of reciprocal duties on goods from the U.S. and/or diminished purchases of U.S. treasuries.  One may wonder why the U.S. would run this risk when unemployment is below 5% and overseas economies are fragile.  And while financial markets have shrugged off the possibility thus far, global investors are likely to turn wary if a trade war were to materialize.

One of the most disturbing aspects of all this is how world leaders today have lost sight of the benefits that free trade has conveyed on the U.S. and global economy during the post-war era.  From the early 1980s, when globalization took off, until the mid-2000s,    there was a fairly steady expansion of both world trade and economic growth, with world trade expanding at roughly twice the pace of global GDP growth, and free trade policies played a critical role (see chart).  However, in the wake of the 2008 financial crisis, both global growth and the volume of world trade slowed markedly. This development, in turn gave rise to populism around the world, which threatens to bring increased protectionism that could undermine what was achieved during the post-war order.

Growth in Volume of World Goods Trade & Real GDP, 1980-2015

Source:  International Monetary Fund, World Economic Outlook Database, October 2016.

[1] See WSJ article, “Donald Trump Warns on House Republican Tax Plan,” January 16, 2017.

SEC Chair White Urges Successor to Prioritize Globally Accepted Accounting Standards

SEC Chair Mary Jo White called on the “next Chair” of the Commission to prioritize the development of “high-quality, globally accepted accounting standards,” which are “imperative for the protection of U.S. investors and companies and the strength of our markets”:

“I strongly urge the next Chair and Commission to build on our past efforts and give the goal of high quality globally accepted accounting standards the focus and support this critical issue deserves.”

In a public statement, Chair White noted that as of September 2016, foreign companies that apply International Financial Reporting Standards (“IFRS”) in SEC filings represent “a worldwide market capitalization in excess of $7 trillion across more than 500 companies.” U.S. companies use IFRS in making acquisitions, establishing joint ventures and preparing financial information for management and boards of directors, she stated.

“In light of these global realities,” Chair White urged the “next SEC Chair” to:

  • work with the Financial Accounting Standards Board (“FASB”) to “provide clear and reliable financial information as business transactions and investor needs continue to evolve globally”;
  • work closely with the SEC Chief Accountant and be an active member of the IFRS Foundation Monitoring Board; and
  • ensure that the SEC carefully monitors “how the needs and interests of investors and issuers may change in the future and seek opportunities to guide and accelerate the development of high-quality, globally accepted accounting standards.”

In addition, Chair White encouraged the IFRS and the Financial Accounting Standards Board to “continue their productive collaboration,” particularly by adopting a “sequential” approach to the convergence of their respective accounting standards.

Lofchie Comment: Some of the most unfortunate incidents that occurred during Chair White’s tenure were the recurrent attacks she suffered under Senator Warren’s acerbic scrutiny. Those attacks were wholly undeserved, since the Senator’s objective was to compel the SEC to focus on adopting rules that had a significant political purpose (such as the disclosure of political contributions) but only tangential relevance to the SEC’s aims, as opposed to rules that should be more important to the SEC, such as those that improve economic transparency. (Seee.g.Senator [Warren] Urges President to Replace SEC Chair.)

To Chair White’s credit, she did not allow these attacks to distract the SEC from pursuing its core mission. Even in her parting words to the Commission, Chair White fixed her attention on the task at hand: improving economic disclosures that may benefit investors and the U.S. economy.

NY Fed Issues New Policy on Counterparties for Market Operations

The Federal Reserve Bank of New York issued a comprehensive overview of its counterparty framework, which includes a new policy on counterparties for all domestic and foreign market operations. The new counterparty policy is the result of a multi-year review of the framework for counterparty relationships across the full range of the trading desk operations in domestic and foreign financial markets.

Highlights from the new policy include:

  • reducing the minimum net regulatory capital (“NRC”) threshold for broker-dealer counterparties from $150 million to $50 million, in order to broaden the pool of eligible firms;
  • raising the minimum Tier 1 capital threshold for the banks, branches, and agencies of foreign banking organizations from $150 million to $1 billion, to better align the Tier 1 threshold with the new NRC threshold (which is measured with respect to Tier 1 capital of the bank holding company); and
  • introducing a 0.25% minimum U.S. government market share threshold as a means to more directly quantify the business capabilities of firms that express interest in becoming a primary dealer.

Under the new policy, counterparties will be expected to:

  • operate in accordance with the Best Practices for Treasury, Agency Debt and Agency Mortgage-Backed Securities Markets (published by the New York Fed-sponsored Treasury Market Practices Group) and FX market best practices guidance (such as the Global Preamble, promulgated by the New York Fed-sponsored Foreign Exchange Committee);
  • provide insight to regulators on an ongoing basis into developments in the markets in which they transact;
  • meet any minimum capital thresholds or other standards that are set forth by their primary regulator;
  • provide information (as needed) for counterparty risk management and monitoring; and
  • establish a compliance program that is consistent with the sound practices observed in the industry, and support adherence to the terms of its counterparty relationship with the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York also provided the following materials for firms interested in becoming a counterparty:

The new policy and eligibility criteria are immediately effective.

Lofchie Comment: It is notable that the New York Fed reduced the capital requirements for primary dealers, while at the same time increasing those requirements for counterparties to foreign exchange transactions. Further, one could question whether reduced capital requirements for primary dealers reflect diminished market interest in operating as a primary dealer.

ISDA Analyzes Key Trends in Clearing

In its latest Research Note, ISDA examined recent trends in the clearing business in the United States and the European Union.

The ISDA Research Note found, among other things, that:

  • shifts occurring in the business models of futures commission merchants (“FCMs”) due to the impact of new capital requirements and rising operational costs have led to significant changes in the market share of top FCMs in the United States;
  • some derivatives users were dislocated from their existing FCMs and needed to establish relationships with new FCMs in order to continue using swaps mandated for clearing;
  • FCMs are imposing increased costs on smaller derivatives users (survey results in the United States estimated fees from $60 to $150K over the life of a cleared swap); and
  • monthly mandatory minimum clearing fees and minimum revenue thresholds among larger clearing members in the European Union could range from $100,000 to $280,000 per year, and that range of costs is becoming increasingly common in the United States.

In conclusion, ISDA noted, one of the main effects of the increased cost of cleared swaps is this: end users are being pushed to choose alternative hedging measures and/or accept greater risks by either not hedging or using imperfect hedges.

Lofchie Comment: The bottom line of ISDA’s analysis is that, (i) despite all of the outcry about too-big-to-fail, regulatory costs weigh most heavily on smaller institutions, whether buy-side or sell-side, and (ii) increasing the costs of entering into derivatives transactions makes hedging more expensive, which increases risk in the economy generally, even if the risk of derivatives specifically is decreased. To put this in practical terms, if a small firm is prevented from hedging with derivatives in a way that would reduce that firm’s risk, then (a) the risk of derivatives seems to be reduced (since you can’t default on a derivative into which you can enter), but (b) the actual risk to the business (and to the economy generally) is increased because the small firm can’t hedge.