Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: the Treasury market, ESG, and vaccine expectations.

In March, when the Covid crisis entered full swing, the deepest, most liquid securities market in the world — that for U.S. Treasuries — froze up. The “dash for cash” catalyzed by the Covid sell-off led banks and asset managers to unload their Treasury holdings just as demand dried up. Yields rose sharply until the Federal Reserve intervened with a pledge to make as many purchases of Treasuries as necessary to stabilize the market.

U.S. government bonds are essentially a form of currency. Financial institutions mark Treasury bills as “cash equivalents” on their balance sheets. When they need cash, they either post Treasuries as collateral for short-term funding or else sell them on the open market. Protracted illiquidity in the Treasury market would cut off funding to scores of otherwise-healthy businesses.

The Fed’s Treasury purchases stabilized the market, but such a massive intervention is hardly a sustainable stabilization mechanism, and “fire sales” are a relatively common feature of financial panics. Why weren’t policymakers prepared? One reason is post-2008 financial regulations, which raised capital requirements for broker-dealers and diminished the market-making ability of financial institutions. While regulations such as the Volcker Rule reduce the amount of risk on banks’ balance sheets, they also reduce the ability of banks to take on risk from other market participants.

In the wake of the Treasury meltdown, some economists are calling for broader reform to the structure of the market. Stanford’s Darrell Duffie argues that “as a design principle, the lack of a robust private-market structure should not be acceptable based on the notion that the Fed can rescue the market as a last resort.”

He suggests central clearing of Treasuries as a means of reducing counterparty risk and increasing liquidity. Brokers and dealers would fund a central clearinghouse and settle trades through that entity rather than settling them bilaterally.

Central clearing increases the transparency of settlement risk to regulators and market participants, and in particular allows the CCP to identify concentrated positions and crowded trades, adjusting margin requirements accordingly. Central clearing also improves market safety by lowering exposure to settlement failures, which rose significantly during the most stressful days in March…

Central clearing also reduces the amount of dealer balance-sheet space necessary to maintain liquid markets. This arises from improved netting, by which a dealer’s commitments to settle a buy trade with one counterparty and a sell trade with another can both be novated to the CCP, so that the dealer’s settlement commitment and counterparty exposure is only the net of those of the buy and sell trades.

It’s not a new idea. Exchange operator Nasdaq called for just such a market structure in 2017. Whatever path regulators choose, the Treasury market will likely see permanent changes in the aftermath of the pandemic.

— D.T.

Scratch a little below the surface of some strains of environmentalism and it is easy to see the love of asceticism for its own sake, something that has been all too common in cults throughout the ages. It was thus probably inevitable that what we eat would be caught up in the discussion of how to deal with climate change, and it was no less inevitable that the foodstuffs that fall foul of the climate warriors would be among those that taste the best.

And where the climate warriors lead, you can be sure that “socially responsible” investors—and those who feed off them—will follow.

The Financial Times:

Climate campaigners have spent years pushing for defunding and divestment from fossil fuel companies. Now, as their arguments gain traction, they are taking aim at the emissions-heavy meat and dairy industries.

“At some point those companies will no longer generate any revenue due to ecological limits. The financial markets aren’t pricing in those risks,” said Mark Campanale, founder of Carbon Tracker, the think-tank that popularised the notion that global warming would lead to unviable “stranded assets” in the hydrocarbon sector.

The notion of “stranded assets” was essentially a self-fulfilling prophecy. Persuade enough investors that a profitable, cash-generative asset—from oil reserves to coal mines— is in fact value-destructive, then companies, particularly the larger ones increasingly in thrall to the notion of “stakeholder capitalism”, will struggle to divest them (thus rendering the asset “stranded”) until some cold-hearted contrarian swoops in and picks up a bargain.

Glancing at Carbon Tracker’s website, it’s not hard to see the corporatist dynamic (stakeholder capitalism is little more than an expression of corporatism) at play. A section entitled “Our History, Impact & Funding” explains:

A significant part of our overarching influence emerges through our work with the financial, business and general press globally, as well as engaging directly with institutional investors and the fossil fuel industry, prompting responses. We also engage with governments and regulators worldwide, greatly enhancing our ability to speak at the strategic level and influence the wider landscape. As seen from the impact of our analysis and research, the concepts and conclusions of our work has been amplified far beyond environmental circles and into the mainstream financial community.

The funding?

Well, Bloomberg Philanthropies are there (of course they are). Other donors include Horizon 2020 of the European Union, as well as something called the European Climate Foundation, a foundation that is also a lucky recipient of funding from Bloomberg Philanthropies, well, you get the picture…

But back to the Financial Times and food:

With rising awareness of the carbon impact of the food system, which the UN Intergovernmental Panel on Climate Change estimates accounts for up to 37 per cent of global emissions, investors are starting to take note.

Arisaig Partners, an emerging markets investor with about £3.7bn under management, divested from dairy companies in Vietnam and Mexico this year after assessing the future impact of carbon pricing — a tool used by many governments to help meet the Paris goals on emissions reductions. Its data suggested that operating profits at the average listed emerging market dairy company would be halved if it had to pay a carbon price, with some ceasing to make a profit….

Nordea Asset Management, part of the Nordic financial services group, announced this summer that its funds would divest holdings of about €40m in Brazil’s JBS, the world’s largest meat company by processing volume.

After a period of engagement with the company on environmental, social and governance issues, NAM “did not feel that we were seeing the response that we were looking for”, said Eric Pedersen, head of responsible investments.

JBS said it was “disappointed” that the relationship was terminated without being notified directly by Nordea, adding that it was not given an opportunity to engage in a meaningful way.

There was a time when “responsible” investing meant maximizing return (on a risk-adjusted basis) for clients, but that was then….

The Financial Times:

The meat and dairy industry regard both the highlighting of financial risks and demands of divestment as “anti-meat” and “alarmist”.

“The livestock sector is very far from being the new fossil fuel industry,” said Kay Johnson Smith, head of the Animal Agriculture Alliance. “Investors who are supporting the sustainable production of safe, affordable and nutritious food should not be targeted as such.”

Frédéric Leroy, professor of food science and biotechnology at Vrije Universiteit in Brussels, believes that investor pressure on the meat and dairy sector, as well as a worsening perception of the industry among consumers, is damaging for farmers.

“Farmers put their soul in what they’re doing, and then are criticised,” he said. “They are under huge amounts of pressure, and it’s no wonder young people don’t want to go into agriculture.”

Prof Leroy warned of the dangers of glorifying new technologies in alternative protein production, such as microbials and 3D printing.

“These are fragile ideas. Farming skills will be lost,” he said. “It will make the food supply dangerously fragile.”

Watch your plates. The “socially responsible” hamburglar is on the prowl.

— A.S.

Around the Web
There’s Verizon, the telecommunications company, and then there’s Citizen Verizon, which is holding a Citizen Verizon Assembly today. The topic: “Education Is Not Up For Debate,” all part, of course, of the company’s “responsibility” effort.


Global equity fund managers are shifting out of New York-listed shares in Chinese firms and into Hong Kong-listed vehicles to counter the risk of forced delistings [an issue we have previously discussed on the Capital Note) , as both Democrat Joe Biden and Republican President Donald Trump promise a hard line on Beijing.

And currency investors are fretting that a yuan hovering near 16-month highs is priced for a Biden win, and a calmer tone in diplomacy, which could swiftly unwind if Trump is victorious.

Their bets are focused less on the outcome and more on what most expect to be a rollercoaster period until at least polling day on Nov. 3.

“It doesn’t matter if Biden or Trump will be elected. The bipartisan consensus is to be tough on China,” said Chen Jiabeng, fund manager of Xiamen Portfolio Management Co, which helps investors allocate assets through funds of funds.

“We will not bet on direction. We will bet on higher volatility,” he said.

The switch from New York to Hong Kong listings was to be expected, but the focus on volatility at election time is again worth watching. Note the reference to “until at least polling day” and with it the suspicion that the day after is not going to bring much by way of calm.  Interesting to see the yuan as (in a sense) a Biden play. It brings back memories of this (from CNBC, almost exactly four years ago):

[T]he foreign exchange market seems pretty sure Democratic presidential candidate Hillary Clinton beat her opponent.

Throughout the course of the 90-minute debate which veered widely on issues ranging from Republican candidate Donald Trump’s possible failure to pay taxes to Clinton’s email server, the Mexican peso surged against the U.S. dollar.

The greenback was fetching 19.5360 Mexican pesos at 10:48 a.m. Wednesday HK/SIN, down from as high as 19.92 pesos before the debate began; that was the lowest for the peso since at least 1989, according to Reuters data. That compared with levels below 17 pesos around the beginning of the year.

Analysts said that was a sign the foreign-exchange market was calling the debate a win for Clinton.

“The peso has come up because the market has judged the odds of Trump winning have gone down,” said Ray Attrill, co-head of foreign-exchange strategy, at National Australia Bank. “The peso has been the weapon of choice for betting on Trump winning.”

What could go wrong?


Jenny Lee has a dream: To own an apartment in Seoul, South Korea’s capital, where homes sell at around a $1 million each.

The 27-year-old, who was jobless for a year until last month and rents a room at a dormitory near Seoul, will have her work cut out making that kind of money. She lacks a degree from a “good” college — key to landing a coveted job at conglomerates like Samsung Electronics Co. which dominate the economy, and she is a woman in a country where patriarchal norms have been hard to shake off. In the meantime, she thinks she’s struck on a solution: Day trading.

“In Korea, us 20-somethings only have two ways to get rich: Either we win the lottery or trade shares,” said Lee, whose new job is at a hospital, perhaps the only big employer in these Covid-19 times. “We know we will never be rich on whatever wages we earn. We will never earn enough to buy a home.”

Random Walk
Financial markets can tell us a great deal about the future. Valuations aggregate the predictions of market participants, allowing us to reverse engineer expectations of interest rates, inflation, corporate earnings, etc.

In the case of COVID-19, the biggest question mark is when we’ll get an effective vaccine. In a new NBER working paper, a group of economists uses forecasts of corporate earnings to determine financial analysts’ expectations around vaccines:

An unexpected pandemic lowers current earnings due to costly mitigation and reduces growth rates. Damage depends on the expected arrival of a vaccine that reverts earnings to normal. Using this model, we infer from analysts’ earnings forecasts that, as of mid-May 2020, an effective vaccine is expected in 0.96 years.

Not quite in time for the election, but sooner than the most pessimistic projections.

— D.T.

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