Month: September 2016

Former Philly Fed President Charles Plosser got a lot off his chest this morning during a Bloomberg TV interview. Decrying that central bankers “wring their hands all the time,” Plosser noted that The Fed was very “concerned about credibility,” and was “pretty good at conjuring up reasons not to act.” His mutinous discussion then concluded, soundingvery Trumpian, by noting that The Fed “shouldn’t be afraid a recession might come,” exclaiming “there’s a real problem here” with The Fed.

Additional headlines include:

• *PLOSSER: FED’S `IN A VERY DIFFICULT POSITION’
• *PLOSSER: `THERE’S A REAL PROBLEM HERE’ WITH FED
• *PLOSSER: FED IS VERY CONCERNED ABOUT CREDIBILITY
• *PLOSSER: CENTRAL BANKERS `WRING THEIR HANDS ALL THE TIME’
• *PLOSSER: THERE’S FED DISSENT BECAUSE THERE IS UNCERTAINTY
• *PLOSSER: `DISSENT IS HELPFUL’ FOR FED
• *PLOSSER SAYS FED PRETTY GOOD AT CONJURING UP REASONS NOT TO ACT
• *PLOSSER SAYS FED SHOULDN’T BE AFRAID RECESSION MIGHT COME
• *PLOSSER: WISHES FED ‘WOULD GET ON WITH IT’ AND RAISE RATES
• *PLOSSER: NOVEMBER FED MEETING ‘NOT A DEAD MEETING BY ANY MEANS’

It seems Yellen is losing control of the narrative as more and more insiders ‘get outside’; and perhaps, after all the establishment shock, Trump is right about the political nature of The Fed.

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Having been bullish for nearly half a year, yesterday Goldman’s flipped again, when it cut its Q4 oil price target from $50 to $43, admitting the previously anticipated rebalancing will take longer to achieve, and now expects “a global surplus of 400 kb/d in 4Q16 vs. a 300 kb/d draw previously.” Moments ago, the same Goldman analyst released a follow up note, confirming what we have been saying for the past year, namely that OPEC is increasingly irrelevant as a marginal supply-setter in a world in which it is the lack of demand that is a far bigger threat.

In “OPEC won’t stop oil going”, Damien Courvalin writes that “an OPEC deal to curb oil production, either today or at the November meeting, is thought more likely than at any point in the past two years.” That said, he notes, “we remain sceptical of its impact. For one, our production forecast continues to reflect a seasonal Saudi production decline into year-end, with no growth elsewhere. Second, even with this OPEC help, our updated oil supply-demand forecast now points to a renewed build in inventories in 4Q 2016 vs. a forecast for a draw only last month. This weaker oil outlook into year-end led us yesterday to lower our year-end WTI oil price forecast to $43/bbl, from $51/bbl previously. Given a well-supplied market and a crude curve in contango (with limited spot upside).”

Here are the details behind Goldman’s pessimism:

Intraday oil price volatility has picked up over the past week and ahead of today’s OPEC advisory meeting in Algiers. Statements by participants suggest a deal to curb production today or at the next meeting in November is more likely than at any point over the past two years. We remain sceptical of its impact, for two reasons: (1) independent of today’s outcome, our production forecast continues to reflect a seasonal Saudi production decline into year-end and no growth elsewhere, the equivalent of a deal; and (2) even with this OPEC help, our updated oil supply-demand forecast now points to a renewed build in inventories in 4Q 2016 vs. a forecast for a draw only last month.

This weaker oil outlook into year-end led us yesterday to lower our year-end WTI oil price forecast to $43/bbl, from $51/bbl previously, and still below the forward curve even after yesterday’s sell-off (“Beyond Algiers, weakening oil fundamentals,” September 27, 2016). While a potential OPEC deal today could support prices in the short term, we find that the potential for fewer disruptions and the relatively high speculative net long positioning instead leave risks to our forecast squarely skewed to the downside. Given the uncertainty on forward supply-demand balances, we reiterate our view that oil prices need to reflect near-term fundamentals – which are weaker – with a lower emphasis on the more uncertain longer-term fundamentals.

This renewed weakness in fundamentals reflects the three key drivers of the ongoing oil market rebalancing:

• New Oil Order: Low cost production continues to surprise to the upside, most recently in Saudi Arabia and the UAE, previously in Iraq and Iran, and next in Russia. This relentless production growth reflects the core of the New Oil Order, where the flattening of the oil cost curve created by shale leads to a loss of pricing power by low-cost producers, leaving them with only volume growth to sustain fiscal revenues (“OPEC loses pricing power, shale shifts to the margin,” October 26, 2014).
• Wall of Supply: The ramp up in new production capacity outside of OPEC is set to accelerate into year-end, with 2017 additions of projects started up to 2014 expected to be 30% higher than in 2016 (“The Battle for Capital: A Flatter Cost Curve Drives OPEC Growth and Non-OPEC Deflation,” Top Projects 2016, May 20, 2016). In turn, the US production declines are set to slow even at the current low rig count given the rising age of producing wells (less drilling of new wells) and the much smaller decline rates of mature shale oil wells.
• Détente: Collapsed fiscal revenues are incentivising both a ‘detente’ in areas where geopolitical conflicts have disrupted production as well as a deflationary reduction in local taxation as countries fight to compete with US shale for revenues and capital (“More worried about a thaw than a freeze,” Commodities Research, August 22, 2016). As a result, the surge in short-term production disruptions that balanced the oil market unexpectedly in 2Q 2016 is slowly starting to reverse.

Importantly, even if disruptions remain at current levels in Libya and Nigeria, and Saudi reduces production into year-end, we project that global oil supply will continue to rise in coming months driven by low cost production growth and new project deliveries. We continue to view such supply shifts as the key drivers to oil prices through 2017, especially given today’s high level of inventories. Oil demand growth, and in particular China’s, has remained the bright spot of the oil market over the past two years. This strong demand growth has been supported by both low prices as well as the ongoing rotation from investment to consumption which put downward pressure on demand for CapEx commodities used in infrastructure and manufacturing, such as steel, relative to OpEx commodities exposed to consumer spending, such as oil.

Medium term, we believe that the decline in drilling activity around the world is still setting the stage for an eventual recovery in prices. For now, our 2017 outlook remains unchanged, with demand and supply projected to remain in balance and WTI oil prices to average $53/bbl, with a 1H 2017 expected trading range of $45-$50/bbl. The risks around this forecast remain high, however, with our forecasts conservative on both further low cost production growth and further disruption reversals, which combined represent today 1.6% of global supply, the equivalent of the average global oil surplus observed during 1Q 2015 – 1Q 2016.

Assuming, for example, that global supply exceeds our forecasts by 400 kb/d (0.4%), our models imply that oil prices would need to average $43/bbl on average next year. Such a scenario is not that unlikely as it could be reached either (1) with half of Libya’s and Nigeria’s current disruptions reversing, (2) 2017 non-OPEC new projects coming online in line with company guidance instead of our lower ‘risked’ forecasts, or finally (3) Iran and Iraq delivering on their advertised production growth instead of our more conservative expectations.

Given our outlook for a well supplied market and a crude curve in contango with limited spot upside, we continue to recommend being short the S&P GSCI Crude Oil index, especially paired with positive yielding oil-exposed assets such as HY E&P credit, which is our recommended Top Trade #8.

 

 

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Perhaps the most memorable aspect of Monday’s presidential debate from a policy standpoint, was Donald Trump’s latest attack on the Fed, and its chair, Janet Yellen. As a reminder, Trump repeated a claim he has made before, saying the economy was in a “big, fat, ugly bubble” and went straight for Yellen when he said: “And we have a Fed that’s doing political things. This Janet Yellen of the Fed.” He also gave his version about what might happen next at the Fed.

“On the day Obama goes off, and he leaves, and goes out to the golf course for the rest of his life to play golf, when they raise interest rates, you’re going to see some very bad things happen, because the Fed is not doing their job. The Fed is being more political than Secretary Clinton.“

This puts Yellen in a bind. As AFR’s Philip Baker writes, “Trump’s attack on the Fed chairwoman during this week’s presidential debate was so vicious that Paul Ashworth, chief US economist at Capital Economics, now thinks it’s possible Yellen will have to resign if Trump ends up becoming president.”

While Trump has criticised Yellen in the past on numerous occasions, on Monday night be upped the ante “big league” – Ashworth argues that the “veracity” of the claims are “irrelevant” and it doesn’t even matter if Trump himself doesn’t really believe what he said.

“It’s all to do with how voters react to his comments”, Ashworth notes, adding that “if those claims are made publicly to a viewing audience of up to 100 million Americans, and a majority of those Americans then go on to vote for Trump in November’s election, then what choice does Yellen have? It’s true that Yellen might still have the support of Congress, but she could not argue that she enjoys the confidence of the American people” he wrote in a note to clients.

To be sure, Yellen isn’t the first head of the Fed to cop it from presidential hopefuls during their campaigns. In 2011 Ben Bernanke wore a few barbs from Republican candidate Rick Perry when he was accused of “treasonous” behaviour after the Fed started its program of quantitative easing. There had also been some tension with Fed chiefs when George H.W.  Bush and Richard Nixon were presidents.

To be sure, in most respects, Trump is right and the Fed is indeed a political creature, as the following anecdote from the NYT reveals clearly:

in 1965, President Lyndon B. Johnson, who wanted cheap credit to finance the Vietnam War and his Great Society, summoned Fed chairman William McChesney Martin to his Texas ranch. There, after asking other officials to leave the room, Johnson reportedly shoved Martin against the wall as he demanding that the Fed once again hold down interest rates. Martin caved, the Fed printed money, and inflation kept climbing until the early 1980s.

But while the Fed’s implicit role in US politics, and especially its funding, is nothing new, never before has the central bank played such a prominent role in every aspect of the economy, and certainly capital markets.

Which brings us back to Trump’s talking point: “Trump’s criticism of the Fed last night was clearly a prepared talking point. The chances are that he will return to it in the remaining two debates,” Ashworth said.

So what would happen under a Trump presidency? Ashworth thinks that Yellen would resign fairly quickly as a matter of principle and it throws a spanner in the works for the Fed.

“If Yellen’s resignation triggered a renewed bout of market turbulence then that would make a December rate hike less likely anyway. Even if Yellen stays, however, given his stance on both trade and fiscal policy, a Trump win could trigger an adverse market reaction that persuades the Fed to hold fire” he wrote. 

Come to think of it, for those who have railed against the Federal Reserve’s for years, accusing it correctly of its encroaching takeover of every aspect of the US economy, enabling the government’s nearly $10 trillion debt issuance spree since the financial crisis, not to mention its takeover of capital markets – manifesting most vividly in a hedge fund industry that is slowly imploding having no clue how to trade today’s “market” – perhaps merely a Yellen resignation would be a sufficient reason to get Trump inside the White House.  And yes, risk assets would not be happy with such an outcome.

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• Stocks Rally as Deutsche Bank Slump Ends, Oil Gains Before Talks (BBG)
• German government prepare Deutsche Bank rescue plan (Reuters)
• German financial watchdog not working on emergency plan for Deutsche Bank (Reuters)
• Saudi Arabia Signals Openness to Future Oil Compromise With Iran (BBG)
• Anheuser-Busch InBev Clinches $103 Billion SABMiller Deal (BBG)
• Will Congressional Face-off Over Flint Lead to a Government Shutdown? (NBC)
• Shimon Peres, Israel’s last founding father, dies at 93 (Reuters)
• Elon Musk Outlines Plans for Missions to Mars (WSJ)
• Crowds gather after police fatally wound unarmed black man in southern California (Reuters)
• Five arrested on suspicion of forming European Islamic State cell (Reuters)
• It’s Paul Singer Versus Citigroup in High-Stakes Bankruptcy Feud (BBG)
• UniCredit to announce capital raising after Italian referendum (FT)
• China’s Ambitious Plan to Make the Yuan the World’s Go-To Currency (BBG)
• Wells Fargo CEO forfeits millions as board orders review (Reuters)
• Deutsche Bank Rises as CEO Sells Assets, Rules Out Capital Hike (BBG)
• Taliban ‘very interested’ in debate, watched from secret location (The Hill)
• Senators Propose Bill to Include Municipal Debt as Liquid Assets (BBG)
• Norway appeals court rejects Snowden extradition lawsuit (Reuters)
• German consumer morale falls slightly heading into October (Reuters)
• Putin faces dilemma after vote win: How to prolong a system based on himself (Reuters)
• Uber to Launch Food-Delivery Service in Tokyo (WSJ)

 

Overnight Media Digest

WSJ

– Wells Fargo & Co Chief Executive John Stumpf will forgo his salary and forfeit $41 million in unvested equity awards during an investigation into the bank’s sales practices. http://on.wsj.com/2dqnbnC

– Billionaire Elon Musk unveiled his vision for sending humans to Mars in roughly the next decade and ultimately setting up colonies there. http://on.wsj.com/2dqoeDZ

– Uber Technologies Inc plans to launch its food delivery business, UberEats, in Tokyo on Thursday. http://on.wsj.com/2dqnBdA

– Canada gave conditional approval on Tuesday to Malaysia’s state-owned energy company Petroliam Nasional Bhd, clearing the final regulatory hurdle facing the C$36 billion project. http://on.wsj.com/2dqmzOT

 

FT

French presidential candidate Nicolas Sarkozy said on Tuesday he would offer Britain a chance to reverse its Brexit vote by negotiating a new treaty for the European Union with Germany, if he wins presidency in 2017.

The U.S. Department of Justice is investigating whether Standard Chartered Plc failed to stop possible bribery and other misconduct at MAXpower Group Pte Ltd, which builds and operates gas-fired power plants in southeast Asia.

Greek lawmakers on Tuesday passed reforms sought by the country’s creditors to cut pension spending and expedite privatisations in exchange for financial aid under the country’s latest international bailout

 

NYT

– Wells Fargo announced that it would claw back compensation valued at $41 million from its embattled chairman and chief executive, John Stumpf, as the financial consequences of the scandal over illegally created sham accounts at the bank reached the executive suite. http://nyti.ms/2d8NPNP

– Maurice Greenberg, the former chief executive of insurance giant American International Group Inc, took the witness stand for the first time in his state civil accounting fraud trial in State Supreme Court in Manhattan. http://nyti.ms/2cBBOmG

– Jim Yong Kim, 56, a public-health official and former president of Dartmouth College, was unanimously appointed by the World Bank’s executive directors to a second five-year term as president, according to a statement released by the bank on Tuesday. http://nyti.ms/2d8tom5

– Charles Schultze, 91, an economist who was President Lyndon Johnson’s budget director and President Jimmy Carter’s chief economic adviser, died on Tuesday at his home in Washington. http://nyti.ms/2cUBkUN

– Greek lawmakers approved a new set of austerity measures on Tuesday evening, including further trims in pensions and the transfer of major state assets to a new privatization fund to be overseen by the country’s creditors. http://nyti.ms/2drs7s4

 

Britain

The Times

AG Barr is planning cut 10 per cent of its workforce as it attempts to improve efficiency in an increasingly tough soft drinks market. (http://bit.ly/2dq1lMr)

Standard Life Investments has become the latest financial institution to announce plans to reopen its suspended property fund after declaring that the commercial property market had stabilised. (http://bit.ly/2dq138m)

The Guardian

The International Monetary Fund has warned that free trade is increasingly seen as benefiting only the well-off and that help is needed for those whose job prospects have been damaged by globalisation in order to reduce barriers to international trade. (http://bit.ly/2dpYROd)

The owner of Alton Towers has been fined a record £5 million ($6.51 million) for the rollercoaster crash that left five passengers with life-changing injuries and some others seriously hurt. (http://bit.ly/2dpYjaW)

The Telegraph

The Football Association decided that Sam Allardyce had to go as England manager following the revelations in a Daily Telegraph investigation because it is “the guardian of the game” and he had fallen below the standards expected. (http://bit.ly/2dpZEij)

Sky News

City Hall is currently working on proposals for separate work visas system for London as the capital looks to carve out a bespoke deal on immigration in Brexit Britain. (http://bit.ly/2dpYy61)

Heating and plumbing supplier Wolseley said it is planning to cut 800 jobs and close 80 branches and one distribution centre in the UK. (http://bit.ly/2dpYD9B)

The Independent

Labour MPs have publicly debated for the first time whether a so-called “universal basic income” should be introduced to replace the existing benefits system in place in the UK. (http://ind.pn/2dq0wTJ)

According to treasury officials, a so called “hard Brexit” deal, which would see the UK drifting away from cooperation with the rest of the EU, could cost the UK Exchequer at least £10 billion ($13.02 billion) a year. (http://ind.pn/2dq1mjm)

 

 

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After yesterday’s broad “Hillary rally” gains in the US, overnight’s session has seen more risk-on sentiment as European stocks advanced, ignoring some weakness in Asia and especially Japan (Nikkei was down 1.3%) as investors followed every twist of shares of beleaguered lender Deutsche Bank, whose CEO last night assured Bill readers that the bank is not seeking a bailout, which however was contradicted by a Zeit article this morning reporting that Germany may seek as much as s 25% “bailout” stake in a worst case scenario. This report, too, was promptly denied by the German finance ministry, however not before push US equity futures back into the red.

Beyond banking sector worries, investors were looking ahead to U.S. Federal Reserve Chair Janet Yellen’s appearance before a Congressional committee, a speech by European Central Bank President Mario Draghi and a meeting of oil producers in Algiers.

Crude oil climbed before a meeting of major producers in Algiers, even thought Saudi Arabia and Iran have said there’s little chance of an immediate agreement. Nonetheless, Saudi Arabia gave the strongest indication yet it’s ready to compromise with regional rival Iran, potentially paving the way for the first limit on oil production in two years, although a deal is unlikely until OPEC’s next meeting in November. In other words, algos will now be focusing only on OPEC headlines about the November meeting. Khalid Al-Falih, who inherited a chronically oversupplied oil market when he was appointed Saudi energy minister in April, appeared to show more flexibility toward Tehran, saying that Iran, Libya and Nigeria s hould be allowed to “produce at the maximum levels that makes sense”. “The gap between OPEC countries is narrowing in terms of what are the levels at which we will freeze,” Al-Falih said after a long day of bilateral meetings in which Russia played the role of mediator between Riyadh and Tehran. “The opinions are getting very, very close together.” Of course, we’ve heard it all before.

Going back to stocks, the Stoxx Europe 600 climbed for the first time in four days as Deutsche Bank agreed to sell its U.K. insurance unit and Chief Executive Officer John Cryan ruled out a capital increase. Oil stabilized around $45 a barrel before the gathering OPEC members to discuss ways to boost oil prices, including potential output constraints. A gauge of the dollar rose from a two-week low.

Shares in Germany’s biggest lender fell to a record low this week, dragging down European financial stocks, after the U.S. Department of Justice requested $14 billion to settle claims tied to fraudulent mortgage-backed securities. While the bank said it won’t pay anywhere close to that amount, the news fueled doubts over its capital levels and refocused investors on the industry’s faults. Meanwhile, crude prices, a key determinant of global stock moves this year, have been whipsawed over the past week on prospects for an accord to limit production.

“Banks picked up a bit following Cryan’s comments,” said Patrick Spencer vice chairman of equities at Robert W. Baird. “That helped sentiment and the outlook for growth looks reasonable. The oil recovery is helping basic materials.”

[Deutsche Bank has] got an OK CET1 ratio right now and they’ve got to improve it — you can see how asset sales make sense,” Patrick Armstrong, managing partner at Plurimi Wealth, told Bloomberg. “Any equity issuance would be incredibly dilutive right now with the overhang of fines facing Deutsche Bank, so they don’t want to be doing that right now.”

The Stoxx Europe 600 Index added 0.6 percent in early trading, while Deutsche Bank rose 1.8% after agreeing to sell Abbey Life Assurance Co. to Phoenix Group Holdings for 935 million pounds ($1.2 billion).  Bild reported Cryan as saying he hasn’t sought help from German Chancellor Angela Merkel. The government is preparing a contingency plan, according to German newspaper Die Zeit. The bank’s riskiest bonds rose, with 1.75 billion euros of 6 percent additional Tier 1 notes climbing three cents on the euro to 75 cents, the highest in almost a week, according to data compiled by Bloomberg.

Royal Bank of Scotland Group Plc also advanced after it agreed to pay $1.1 billion to settle National Credit Union Administration claims that it sold faulty mortgage-backed securities to U.S. credit unions.
Anglo American Plc and Rio Tinto Plc led commodity producers higher, with gains of 2 percent or more, as base metal prices advanced.

In the US, S&P 500 Index futures slipped 0.1%, after U.S. equities climbed on Tuesday. Investors will look to data Wednesday on durable goods orders in August for indications of the health of the world’s biggest economy, with economists forecasting a decline from July. Nike Inc. dropped 2 percent in European trading after the maker of sneakers and athletic apparel posted futures orders that missed analysts’ estimates.

Saudi Arabian stocks fell, heading for the biggest two-day slump since January. The Tadawul All Share Index has lost 6 percent in the period after the kingdom canceled bonus payments for state workers and cut ministers’ salaries. The moves were part of new measures by the world’s largest oil exporter to contain the budget deficit following a slump in crude prices.

Finally, a quick look at the world of central bankers losing confidence, Japanese 10Y bonds climbed, pushing their yield to a one-month low of minus 0.09%. That compares with the Bank of Japan’s target of about zero for the rate and Mitsubishi UFJ Morgan Stanley Securities Co. said yields are approaching levels that could convince the authority to slow its debt purchases, and effectively taper its QE. The rate on 10Y Bunds was little changed at -0.14%. Portuguese bonds rallied, sending the 10-year yield eight basis points lower to 3.33 percent. 19Y US paper was yielding 1.577%.

Market Snapshot

• S&P 500 futures down 0.1% to 2150
• Stoxx 600 up 0.5% to 342
• FTSE 100 up 0.5% to 6844
• DAX up 0.8% to 10442
• German 10Yr yield down less than 1bp to -0.15%
• Italian 10Yr yield up less than 1bp to 1.22%
• Spanish 10Yr yield up 2bps to 0.92%
• S&P GSCI Index up 0.2% to 351.2
• MSCI Asia Pacific down 0.7% to 141
• Nikkei 225 down 1.3% to 16465
• Hang Seng up 0.2% to 23620
• Shanghai Composite down 0.3% to 2988
• S&P/ASX 200 up 0.1% to 5412
• US 10-yr yield up 1bp to 1.57%
• Dollar Index up 0.09% to 95.52
• WTI Crude futures up 0.4% to $44.84
• Brent Futures up 0.6% to $46.24
• Gold spot down 0.2% to $1,325
• Silver spot down less than 0.1% to $19.13

Global Headline News

• Wal-Mart in Talks to Invest Up to $1b in Flipkart: WMT would take a minority stake in Flipkart under proposed agreement, according to person familiar.
• Deutsche Bank to Take $895m Charge on Abbey Life Unit Sale: Co. to book pretax loss of ~EU800m from sale of its U.K. insurance unit; Deutsche Bank Rises; CEO Sells Assets, Rules Out Capital Hike
• Nike Orders Miss Estimates, Renewing Concerns About Slowdown: Orders rose just 1% in North America as of Aug. 31.
• U.S. Faults Foot-Dragging Banks Amid Deutsche Bank Talks: DoJ said that several lenders caught up in long-running mortgage securities investigations had dragged out govt’s work.
• Wells Fargo’s CEO Forfeits $41m in Fight to Keep His Job: John Stumpf to forgo >$41m in stock, salary as bank’s board investigates how employees opened legions of bogus accounts for customers.
• Cisco to Add Jobs in Mexico as Part of $4b Spending Plan: Investment will lead to creation of 270 new Cisco jobs, 77 outside positions.
• Hedge Funds Face Most Difficult Era Robertson’s Ever Seen: “That type of business hasn’t worked lately, and it’s a tough business,” Julian Robertson said Tuesday night in Bloomberg interview.
• Goldman Says Can Beat Fintech Ventures With Online Loans: Using deposits to fund loans will give bank more leeway when setting terms and fees, Stephen Scherr, head of banking operations, said at conference.
• Caesars Deal Boosts Appaloosa After Apollo, TPG Give Ground: David Tepper’s fund more than doubles recovery in casino case.
• Freeport’s $2 Billion Anadarko Sale Said to Face Lender Snag: Some creditors want more money, greater protection for allowing sale of oil & gas assets to Anadarko.
• Pimco Says It Will Probably Be Onshore in China in Year or 2: “Most recently we’ve seen regulations change,” head of Asia Pacific Eric Mogelof said at Bloomberg Markets Most Influential Summit in Hong Kong.
• Tyson Recalls 60 Tons of Chicken Nuggets on Contamination Fears: Recall prompted by “small number of consumers” telling co. they found pieces of hard, white plastic in nuggets.
• Elliott, Aurelius vs Citi in High-Stakes Bankruptcy Feud: Battle has funds against Citigroup-led pool of lenders.
• Yearlong Rush to Muni Funds Leaves Investors Wary of Exodus: This week may mark fifty-second straight with inflows to state, local-govt bond funds.
• COTY Replaces DO in S&P 500; TTS Replaces EPIQ in SmallCap 600

* * *

Looking at regional markets, we start in Asia where stocks failed to take the impetus from the positive lead from the strong US close, with the region mostly lower amid weakness across commodities. Nikkei 225 (-1.5%) was the laggard with commodity-related sectors suffering after oil prices fell nearly 3% amid doubts regarding an output freeze deal, while gold prices also dropped over USD 10/oz in the prior session after US Consumer Confidence rose to its highest since August 2007. This also weighed on commodity names in the ASX 200 (+0.1%), although losses were stemmed by strength in utilities, led by AGL Energy. Shanghai Composite (-0.3%) and Hang Seng (+0.2%) conformed to the lacklustre tone after the WTO forecasted world trade to grow at its slowest pace since the GFC, with Hong Kong markets the underperformer on amid a lacklustre debut from Postal Savings Bank of China. 10yr JGBs were higher amid risk averse sentiment in Japan and the BoJ also in the market for over JPY 1.1tIn of government debt, while Japanese yields remained pressured in which the 2yr yield declined to its lowest in around 2 months.

Top Asian News

• South Korean Court Is Considering Sale of Hanjin Shipping: Court prefers to have companies in industry take over Hanjin
• Postal Bank Makes Tepid Debut Amid Report Soros Fund Invested: Chinese lender’s IPO was biggest since Alibaba in 2014
• Abe Clashes With New Opposition Leader Over BOJ Inflation Policy: Renho calls monetary policy a ‘failure,’ criticizes GPIF
• Duterte Woos Army as Opponents Warn of Discontent in Ranks: Peso sinks, global funds sell, as rhetoric spooks investors
• BoAML Sees China Crisis, BlackRock Only Bumps in Road: Views differ on how much room Chinese government has to move

In Europe, after a turbulent start to the week, the pressure on local equities subsided today to see Euro Stoxx 50 trading higher by +1.1%, with Deutsche Bank (+2.3%) among the best performers today to pare some of the recent heavy losses after CEO Cryan sought to quell concerns overnight in an interview with Bild, whereby he played down the possibility of capital raising, while stating there are fewer risks than before and reassuring that the bank has enough liquidity. This was then followed up by reports in German press suggesting that the German state were planning a contingency plan for the Co. (albeit in extreme circumstances) which pressured the Co.’s shares by highlighting the severity of the situation. However, Co. shares then pared this move as the plan was said to involve the German state potentially taking a stake in the Co. — contrary to comments from German Chancellor Merkel over the weekend. On a sector breakdown, alongside the upside in financials, energy and material names are also among the best performers, again retracing some of the recent downside. The most notable moves in fixed income have come from the periphery, with Greek bonds rallying after positive comments from Greek PM Tsipras, suggesting that the second Greek bailout review is to conclude on time and is anticipating positive news on debt by the end of the year. In terms of supply, this morning saw the market absorb the latest Schatz auction from the Buba, although little in the way of price action was seen in the German 2yr.

Top European News

• German Govt Working on Deutsche Bank Contingency Plan: Die Zeit: Possible scenarios include capital injection to cover litigation costs, also option of German govt taking a stake; Deutsche Bank Should Slash Bonuses of Staff, Autonomous Says
• Bank of England’s Shafik Sees Further Easing Likely for U.K.: “It seems likely to me that further monetary stimulus will be required at some point, ” says BOE dep. governor Minouche Shafik.
• RBS Will Pay $1.1b in Settlement Over Mortgage Securities: Bank to settle National Credit Union Administration claims it sold faulty MBS to U.S. credit unions.
• SABMiller Name to Disappear as Shareholders Vote: AB InBev to keep its name after shareholders approved acquisition at a meeting in Brussels.
• Pound Set for Longest Run of Losses Since 1984 on Brexit Woes: pound headed for its fifth quarterly decline versus the dollar, the longest run in 32 years

In FX, the Bloomberg Dollar Spot Index climbed 0.2 percent, gaining for the first time this week. Fed Chair Janet Yellen will address lawmakers on Wednesday and the lineup of Fed officials due to make speeches includes Loretta Mester and Esther George, both of whom voted in favor of an interest-rate increase at last week’s policy review. The central bank held borrowing costs steady on Sept. 21 and futures prices reflect roughly 50-50 odds of a hike by December, down from 61 percent a week ago. “The market is waiting on fresh direction, potentially from some Fed speakers tonight,” said David Forrester, a foreign-exchange strategist at Credit Agricole SA’s corporate and investment-banking unit in Hong Kong. “The dollar is likely to be subject to some temporary downside risk ahead of the U.S. presidential election and will be especially dependent on the opinion polls.” New Zealand’s dollar weakened 0.7 percent versus the greenback, the biggest loss among 16 major currencies. The ringgit approached a three-month low as Tuesday’s drop in oil prices worsened prospects for Malaysia, Asia’s only major net exporter of crude. The yen declined 0.3 percent against the dollar.

In commodities, crude oil was up 0.4 percent at $44.86 a barrel in New York, having posted moves of more than 2 percent for each of the last five days. Prices steadied after industry data indicated U.S. supplies fell by 752,000 barrels last week. An output freeze was first proposed in February and the International Energy Agency sees a global oil glut persisting until late 2017. While no deal is expected today, the door remains open to the possibility of progress when the Organization of Petroleum Exporting Countries next meets in November. “OPEC members are peddling their self interests, and while that’s the case, there can’t be a cooperative effort,” said Michael McCarthy, chief market strategist in Sydney at CMC Markets. “There is little possibility of that coming together. Oil is trapped between $40 and $50 a barrel, and at this stage, there doesn’t appear to be anything on the horizon to break prices out of that range.”

On today’s busy calendar we have lots of important data in the flash durable and capitals goods orders data for August. The market consensus is for a -1.5% mom decline in headline durable goods orders and a -0.1% mom decline in core capex orders. While a modest decline in aircraft orders should weigh on the headline durable orders reading the ex-transportation reading should be little changed according to economists which would be broadly consistent with last month’s performance of ISM manufacturing orders. Away from the data there’s a bunch of Fedspeak to highlight. Fed Chair Yellen is scheduled to testify before the House Panel on bank supervision and regulation. Typically, this is not the venue where the Fed Chair discusses the economy, so the testimony should be a non event for the financial markets. Meanwhile Bullard is due to make comments at 10.15 am followed by Evans at 1.30pm and Mester at 4.35pm. The IMF’s Lagarde also speaks today while the ECB’s Draghi will firstly address a research conference in London this morning at 10am BST followed by a closed session briefing to German lawmakers at 2.30pm BST. He’s also expected to comment to reporters after this briefing. The major Oil producers’ meeting in Algeria is also due to wrap up today.

* * *

Bulletin Headline Summary from RanSquawk and Bloomberg

• After a turbulent start to the week, the pressure on European equities has subsided today to see Euro Stoxx 50 trading higher by +1.1%
• BoE member Shafik reiterated the possibility of further stimulus measures, though if the data warranted, but the headline saw Cable hit back through 1.3000
• Looking ahead, highlights include DoE Crude Oil Inventories, US Durable Goods Orders and a slew of speakers which include ECB’s Draghi & Fed’s Yellen

US Event Calendar

• 7am: MBA Mortgage Applications, Sept. 23 (prior -7.3%)
• 8:30am: Durable Goods Orders, Aug. P, est. -1.5% (prior 4.4%)
• 9:30am: ECB’s Draghi briefs closed session of German parliament
• 10am: Fed’s Yellen testifies before House Financial Services Committee
• 10:15am: Fed’s Bullard speaks in St. Louis
• 10:30am: DOE Energy Inventories
• 1:30pm: Fed’s Evans speaks in St. Louis
• 4:35pm: Fed’s Mester speaks in Cleveland
• 8pm: Fed’s George speaks in Kansas City

DB’s Jim Reid concludes the overnight wrap

Needless to say the focus over the last 24 hours has been on the outcome of the most watched US Presidential Debate in history. As we highlighted yesterday that early CNN poll, which was out just a short time following the exchange, had Clinton coming out best at 62% compared to just 27% for Trump. That was actually the third largest margin of victory for a CNN post-debate poll since 1984. The Mexican Peso – which has emerged as the sentiment proxy for the debate – surged over 2% and had its best day since February but as the dust settled, it was interesting to digest some of the other polls and snippets which eventually emerged.

The first was the reminder of the Presidential Debates during the 2012 election in which the CNN poll recorded a decent margin of victory for Romney over Obama at 67% to 25% in the first debate, only to then be followed by second and third debate victories for Obama, albeit narrowly at 46% to 39% and 48% to 40% (both being CNN polls too). It’s worth noting that the horse-race polls moved in favour of Romney following that first debate. Meanwhile, a raft of other polls yesterday gave for some food for thought too. The following are a list of polls that we found published following the debate, all of which asked the simple question of who won: Time.com (56% vs. 44% in favour of Trump), CNBC (68% vs. 32% in favour of Trump), Fortune (53% vs. 47% in favour of Trump), Public Policy Polling (51% vs. 40% in favour of Clinton), Slate (55% vs. 45% in favour of Trump) and CBS NY (59% vs. 41% in favour of Trump). So including the CNN poll that was 5 out of 7 favouring Trump.

Clearly the reliability of these polls can be brought into question and it may take a few days to see more reliable pollsters emerge. That said, given the subsequent consideration of the additional polls yesterday and also previous trends from the 2012 debate it’ll be interesting to see whether the early consensus view that Clinton emerged as the victor translates into the next batch of poll numbers and perhaps the betting market. As we noted yesterday Trump has been written off many times before and has repeatedly confounded his critics with strong on the ground support. This should all mean that there should be a decent amount of intrigue at the next two battles on October 9th and 14th.

In terms of markets yesterday, despite a very brief dip lower at the open equity markets in the US consolidated gains from the early evening into the close. The S&P 500 eventually closed up +0.64% as tech stocks in particular gained (the Nasdaq was up +0.92%), along with a rebound for financials. The Treasury curve bull flattened again (US 5y30y spread finishing 3.5bps tighter) while credit markets were tighter (CDX IG -1.7bps). A surge in the latest consumer confidence reading certainly helped sentiment (we’ll touch on this shortly) while yesterday’s gains also came despite a backdrop of weaker energy names following a -2.74% tumble for Oil. That was after Iran downplayed hopes for an agreement at the OPEC meeting while the latest twist suggests now that a deal might be more likely when producers meet in November. Oil prices have now increased or decreased at least 2.16% for each of the last five days.

Quickly refreshing our screens this morning it’s been a broadly risk-off start to the day in Asia. There have been heavy losses for bourses in Japan in particular where the Nikkei and Topix have slumped -1.54% and -1.63% respectively with financials slumping over -3%. Elsewhere the Hang Seng (-0.69%), Shanghai Comp (-0.28%) and Kospi (-0.37%) are also down, while the ASX is flat. US equity index futures are also in the red, albeit modestly, while sovereign bond markets are generally stronger. Oil markets are little changed following those declines yesterday.

Back to yesterday. With regards to the economic data, as highlighted earlier the standout was the big jump in US consumer confidence this month to 104.1 from 101.8 in August. The market consensus was actually for a decline to 99.0. The reading is now the highest since August 2007 while the present conditions gauge also jumped to the highest in 9 years. Encouragingly, jobs plentiful also rose to 27.9 and to a post crisis high. Elsewhere, the flash services PMI nudged up nearly 1pt to 51.9 which, if it stays there in the final revision, will put it at the highest level since April. There was less good news in the Richmond Fed manufacturing survey which did improve 3pts this month to -8 but printed below the consensus -2 forecast. Away from the data, Fed-Vice Chair Fischer commented however refrained from speaking directly about the outlook. Instead he chose to focus on the recent decline in unemployment below 5% which has resulted in the economy ‘beginning to see the fruits of a higher pressure labour market’

In Europe our economists noted that the ECB’s August monetary report was on balance disappointing. While money supply (M3) growth did accelerate from 4.9% to 5.1% this was due to ongoing moves into most liquid deposits. The credit side saw negative loan flows to euro area corporates in August and our colleague’s credit impulse measure fell to 0.6% of GDP, the lower end of its range over the past two years. They do however note that we have to be cautious when interpreting August data given the potential seasonality but that said the data is still consistent with their view of a slow growth trend and below consensus 2017 Euro area GDP (forecasting +1.1% yoy). Markets in Europe yesterday were a bit more muted with the Stoxx 600 closing +0.06% and DAX dropping -0.31% as financials suffered further losses.
In the UK Sterling (+0.37%) had a better day after closing back above the $1.30 level. The EU’s economic commissioner, Pierre Moscovici, was the latest to make comments on Brexit and said that UK PM Theresa May needs to trigger the start of negotiations for the EU exit process by the end of March and that any delay beyond that might be too long.

Looking at the day ahead, this morning in Europe the only data due out are the latest consumer confidence indicators for Germany (in October), France and Italy (both September). In the US we’ve got important data in the flash durable and capitals goods orders data for August. The market consensus is for a -1.5% mom decline in headline durable goods orders and a -0.1% mom decline in core capex orders. Our US economists expect durable goods to decline a little less than the market (-1.0% mom forecast) but also expect core capex orders to decline -0.1% mom. While a modest decline in aircraft orders should weigh on the headline durable orders reading the ex-transportation reading should be little changed according to our economists which would be broadly consistent with last month’s performance of ISM manufacturing orders. Away from the data there’s a bunch of Fedspeak to highlight. Fed Chair Yellen is scheduled to testify before the House Panel at 3pm BST on bank supervision and regulation. Typically, this is not the venue where the Fed Chair discusses the economy, so the testimony should be a non event for the financial markets. Meanwhile Bullard is due to make comments at 3.15pm BST followed by Evans at 6.30pm BST and Mester at 9.35pm BST. The IMF’s Lagarde also speaks today while the ECB’s Draghi will firstly address a research conference in London this morning at 10am BST followed by a closed session briefing to German lawmakers at 2.30pm BST. He’s also expected to comment to reporters after this briefing. The major Oil producers’ meeting in Algeria is also due to wrap up today. So a busy day all round!

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Update: In an emailed statement, the German finance ministry told Bloomberg that the report on Deutsche Bank by German weekly Die Zeit “is incorrect” adding that “the federal government isn’t preparing any rescue plans. There are no grounds for such speculation.”

• GERMAN FINANCE MINISTRY DENIES DIE ZEIT REPORT ON DEUTSCHE BANK
• GERMAN GOVERNMENT ISN’T WORKING ON BANK RESCUE PLAN: MINISTRY

Only two more denials until it is unofficially confirmed.

* * *

It’s all about Deutsche Bank this morning again, where after last night’s vigorous denial by CEO John Cryan, who told Bild that the troubled German lender is not seeking a government bailout and that it’s balance sheet is solid, earlier this morning Germany’s Zeit reported that the German government is working on a contingency plan for Deutsche Bank. The German outlet writes that possible scenarios apply in case Deutsche Bank AG needed capital injection to cover litigation costs and include the option of German government taking a stake.

Contingency plan envisages possible sales of Deutsche Bank units, with the option of state guarantees to back the transactions if needed. One worst-case scenario involving the government taking a 25% stake would apply only in extreme emergency. All options are contingency planning and German govt hopes Deutsche Bank won’t need any state aid.

Queried by Reuters, a Deutsche Bank spokesman referred to an interview Chief Executive John Cryan gave German daily Bild on Wednesday and denied the report. “At no point did I ask the chancellor for support. Neither did I suggest anything like that,” had told Cryan Bild in response to a different report that said he had asked German Chancellor Angela Merkel for her support with a $14 billion U.S. demand to settle claims it missold mortgage-backed securities. Such a request would be “out of the question for us,” Cryan said, adding that he could not understand how “anyone could claim that.”

Despite the preemptive denial, Zeit said that the German government is still hoping Deutsche Bank will not need state support and only scenarios for a potential rescue are being discussed so far.

Of course, realizing that such an narrative could promptly trigger a counterparty, if not bank run, moments after German regulator Bafin told Reuters that it is not working on an emergency plan for Deutsche Bank two sources familiar with the situation said on Wednesday.

However, confirming the severity of the situation, earlier today Deutsche Bank also announced it had sold its Abbey Life insurance unit to Phoenix Group Holdings for £935 million ($1.22 billion) in a deal that will boost the German lender’s capital position. Deutsche Bank Chief Executive John Cryan said in a statement that the sale would allow the bank’s asset-management arm to focus on its core business and strengthen its capital position.

As the WSJ adds, the sale, while relatively small, is good news for the bank at a time of renewed investor concerns about its thin capital cushion ahead of a potential multibillion-dollar settlement with U.S. authorities over mortgage-securities probes. The looming charge has sparked concerns that the bank may need to raise fresh funds, and questions about whether Berlin might be forced to support the lender.

The bank said the Abbey Life sale will add about 0.1 percentage point to its common equity tier 1 capital ratio. However, from an income statement basis, the transaction—which is subject to regulatory approval—will result in an expected pretax loss of about €800 million ($897.2 million) because of goodwill impairment.

For Phoenix, the deal will add £10 billion of assets under management, 735,000 new policyholders and boost cash flow to support planned dividend increases. The U.K.-listed business will partly fund the deal through a £735 million rights issue. As part of the transaction, Deutsche has agreed to indemnify Phoenix to cover a potential negative outcome from a U.K. investigation into Abbey Life’s fair treatment of customers and annuity sales practices.

The bottom line: whether a bailout of Deutsche Bank is on the horizon is still up to speculation, and mostly to the market, where should pressure on the company stock and CDS continue, DB may have no choice but to active the “contingency plan.” In any case, US equity futures which until the report were in the green, promptly went south of the unchanged line once the news hit as echoes of the financial crisis get disturbingly familiar.

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Submitted by Soeren Kern via The Gatestone Institute,

• The Islamic State document said that since the establishment of the Spanish Inquisition in 1478, Spain "has done everything to destroy the Koran." It said that Spain tortured Muslims, including burning them alive. Therefore, according to the Islamic State, "Spain is a criminal state that usurps our land." The document calls on jihadists to "reconnoiter airline and train routes for attacks." It also calls on followers to "poison food and water" with insecticides.
• "We will kill any 'innocent' Spanish infidel we find in Muslim lands, and… whether we are European in origin or not, we will kill you in your cities and towns according to our plan." — Islamic State document, May 30, 2016.
• "We will recover al-Andalus, Allah willing. Oh dear Andalus! You thought we forgot about you. I swear by Allah we have never forgotten you. No Muslim can forget Córdoba, Toledo or Xàtiva. There are many faithful and sincere Muslims who swear they will return to al-Andalus." — Islamic State video, January 31, 2016.
• "Spain is the land of our forefathers and we are going to take it back with the power of Allah." — Islamic State video, January 7, 2016.

Islamic militants are stepping up a propaganda war against Spain. In recent months, Islamic State and other jihadist groups have produced a flurry of videos and documents calling on Muslims to reconquer al-Andalus.

Al-Andalus is the Arabic name given to those parts of Spain, Portugal and France occupied by Muslim conquerors (also known as the Moors) from 711 to 1492. Many Muslims believe that territories Muslims lost during the Christian Reconquest of Spain still belong to the realm of Islam. They claim that Islamic law gives them the right to re-establish Muslim rule there.

A recent Islamic State document includes a list of grievances against Spain for wrongs done to Muslims since the Battle of Las Navas de Tolosa on July 16, 1212, when the Christian forces of King Alfonso VIII of Castile routed the Almohad Muslim rulers of the southern half of the Iberian Peninsula. More than 100,000 Muslims were killed in the battle, which was a key victory in the Catholic Monarchs' "Reconquista" of Spain.

The document said that since the establishment of the Spanish Inquisition in 1478, Spain "has done everything to destroy the Koran." It said that Spain tortured Muslims, including burning them alive. Therefore, according to the Islamic State, "Spain is a criminal state that usurps our land." The document calls on jihadists to "reconnoiter airline and train routes for attacks." It also calls on followers to "poison food and water" with insecticides.

The document concludes: "The actions of your ancestors are the reason for our actions today."

On July 15, 2016, Islamic State released its first propaganda video with Spanish subtitles. The high quality of the Spanish translation, both in writing and in syntax, led some analysts to conclude that that the translator's mother tongue is Spanish and that the subtitling may even have been done inside Spain.

On June 3, Islamic State released a video — "Month of Ramadan, Month of Conquest" — which mentions al-Andalus four times. Spain is the only non-Muslim country mentioned in the video.

On May 30, Islamic State released a two-page document in Spanish in which it issued threats directly against Spain. The document states:

"We will kill any 'innocent' Spanish infidel we find in Muslim lands, and if not we will reach your land. Our religion and our faith lives among you, and even though you do not know our names or what we look like and do not even know whether we are European in origin or not, we will kill you in your cities and towns according to our plan, in the same way that you are killing our families."

On January 31, Islamic State released a video in which one of its Spanish jihadists warned Spain that it would "pay a very heavy price" for expelling Muslims from al-Andalus. The eight-minute video included the following statement:

"I swear by Allah that you will pay a very heavy price and your demise will be very painful. We will recover al-Andalus, Allah willing. Oh dear Andalus! You thought we forgot about you. I swear by Allah we have never forgotten you. No Muslim can forget Córdoba, Toledo or Xàtiva. There are many faithful and sincere Muslims who swear they will return to al-Andalus."

An armed, masked Islamic State jihadist appears in a propaganda video, where he warns Spain that it would "pay a very heavy price" for expelling Muslims from al-Andalus hundreds of years ago. The Spanish subtitle above reads "Oh dear Andalus! You thought we forgot about you. I swear by Allah we have never forgotten you. No Muslim can forget Córdoba, Toledo or Xàtiva."

On January 7, Al-Qaeda in the Islamic Maghreb, which is fighting Islamic State for hegemony of North Africa, released a video calling for jihadist attacks in Madrid as a strategy to help Muslims recover the Spanish North African exclaves of Ceuta and Melilla.

Another Islamic State video vowed to liberate al-Andalus from non-Muslims. A jihadist speaking in Spanish with a heavy North African accent said:

"I say to the entire world as a warning: We are living under the Islamic flag, the Islamic caliphate. We will die for it until we liberate those occupied lands, from Jakarta to Andalusia. And I declare: Spain is the land of our forefathers and we are going to take it back with the power of Allah."

Meanwhile, 33 jihadists were arrested in Spain in 17 different raids during the first nine months of 2016, according to the Spanish Interior Ministry.

Most recently, two Spanish citizens of Moroccan origin — Karim El Idrissi Soussi, 27, and a second man identified as 18-year-old O.S.A.A — were arrested in Madrid on jihad terror charges. One of the detainees is a 27-year-old computer science student who watched jihadist propaganda videos in class and threatened to massacre his fellow students.

According to the Interior Ministry, Soussi tried to join the Islamic State but was detained by Turkish authorities while attempting to cross the border into Syria. He was deported and just recently returned to Spain.

The Interior Ministry said Soussi's penchant for radical Islam became evident in November 2015, when the technical training center where he was studying computer science held a moment of silence to honor the victims of the jihadist attacks in Paris. According to teachers and students, Soussi shouted slogans in support of the attacks which killed 130 people, including 89 at the Bataclan Theater.

On other occasions, Soussi publicly justified jihadist attacks by Islamic State, which he said was the ideal form of government for all Muslims. According to the Interior Ministry, Soussi visited a public library almost daily to connect to the internet and browse jihadist websites. He allegedly created fake profiles and posted jihadist material on social media sites. Soussi also criticized so-called moderate Muslims and expressed hope that someday Spain would become an Islamic emirate.

Soussi allegedly watched Islamic State propaganda videos during his computer science class and repeatedly threatened to bring weapons to school to kill his classmates.

The other jihadist, O.S.A.A., was arrested for the offenses of "glorifying jihadist terrorism" and "self-indoctrination for terrorist purposes." The Interior Ministry did not provide further details.

A total of 636 jihadists have been detained in the country since the March 2004 Madrid train bombings, in which nearly 200 people were killed and more than 2,000 injured.

A recent study by the Madrid-based Elcano Institute found that of the 150 jihadists arrested in Spain during the past four years, 124 (81.6%) were linked to Islamic State and 26 (18.4%) to al-Qaeda.

Of those linked to Islamic State, 45.3% were Spanish citizens, 41.1% were Moroccans and 13.6% had other nationalities. In terms of birth, 45.6% were born in Morocco and 39.1% were born in Spain. Only 15.3% were born in other countries.

In terms of immigration, 51.7% were first-generation immigrants, 42.2% were second- or third-generation immigrants, and 6.1% had no immigration background, which implies they are Spanish converts to Islam.

In terms of residency, 29.8% were arrested in Barcelona, 22.1% in Spain's North African exclave of Ceuta, and 15.3% in Madrid. The others were arrested in more than a dozen other localities across the country.

Islamic State has suffered setbacks on the battlefields of the Middle East, but the jihadist terror threat remains undiminished. In the words of Spanish terrorism analyst Florentino Portero: "Islamic State is answering military defeats with more terror."

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In addition to the recent note by Credit Suisse, here, courtesy of a note by UBS’ Felix Huefner, is what you need to know about the upcoming Italian referendum – an event that has been dubbed by some as the most important risk event for Europe in the remainder of the year – scheduled for December 4.

Referendum is about political uncertainty and reform progress

An important forthcoming event is the Italian referendum on constitutional reform, which is scheduled for 4 December. Based on recent opinion polls, the outcome is too close to call. This referendum is important for at least two reasons. First, political uncertainty is affected, as the outcome of the referendum is perceived to impact Prime Minister Renzi’s decision whether to remain in office (despite recent attempts to de-link the content of the referendum from his decision whether to stay in power). This seems to be the key market focus currently. Second, constitutional reform is an important element of the government’s reform agenda. Along with past reforms, such as the one on the labour market, continuing reform is likely positive for the longer-term growth outlook. Possible scenarios for the referendum include: (1) if the referendum is voted down, political uncertainty increases and reform progress takes a step back; (2) if voted in favour, political uncertainty decreases and the reform agenda progresses, potentially including steps to overhaul the judicial system. This double impact arguably increases the importance of the Italian referendum for the outlook.

Implications for Italian government bonds

The associated implications of a ‘No’ vote continue to present a risk to Italian bond spreads. Our expectation of core euro area yields rising gradually over the next few months (supported by upcoming base effects and potential tweaks to the ECB’s QE programme), combined with the fact that the 10yr Italy-Germany spread is close to our year-end target of 125bp, implies a gradual rise in 10yr Italian yields to 1.45% by end- 2016. If a ‘Yes’ vote were to materialise, we would expect 10yr Italy-Germany spreads to initially tighten by 5-10bp. Meanwhile, a ‘No’ vote at the upcoming referendum is likely to result in 10yr Italy-Germany spreads widening to over 155bp. The political backdrop in Spain is currently more favourable than in Italy, and we maintain our preference of being long 10yr Spain versus Italy. We also recommend hedging against a potential escalation of Italian risks by selling 10yr Italy vs US Treasuries (targeting 0bp).

The actual constitutional reform

The constitutional reform that is voted on in the referendum is part of a package aimed at making the political system more stable and facilitating decision-making. The package includes: (1) the electoral reform (Italicum); and (2) reform of the Senate. The first entered into effect earlier this year (but is currently challenged and awaits a decision by the Constitutional Court), while the Senate reform is being decided on 4 December in a referendum.

In broad terms, the Italicum legislative electoral reform replaced proportional representation in the lower house (Chamber of Deputies) with a majority-assuring voting system that attributes a majority bonus to the party (no coalition) with the highest share of votes. The intention is to make the government majority more stable and homogenous. The law came into force in July 2016 (and the next elections in 2018 would be the first held under the new rules). However, the Italicum is viewed controversially and is under review by the constitutional court.

The upcoming December constitutional referendum is about transforming the Senate of the Republic (the upper house) into a Senate of the Regions (a referendum being necessary because the reform failed to achieve a two-thirds majority in parliament). Currently, both the lower house (Chamber of Deputies) and the Senate are elected simultaneously, the government needs the confidence of both houses, and all legislation is passed by both houses. Under this ‘perfect bicameralism’, both chambers thus have equal powers, complicating decisionmaking. Under the reform, the number of senators will be reduced from 314 directly elected to 95 indirectly elected (by the regional councils of Italy) and the participation of the Senate in the law-making procedure will be reduced. Constitutional reform is thus seen by the IMF and the OECD as a key part of the reform agenda to streamline decision-making, along with further implementation of the Jobs Act labour market reform.

The political uncertainty surrounding the referendum outcome

When the referendum was first announced, Prime Minister Renzi specifically noted that, in case of defeat, he would step down as Italian Prime Minister, opening up the possibility of new elections. Over the past few weeks, the perception has been that he has adjusted his position on this matter, stressing that the next general election would be held in spring of 2018 (as originally planned). Another scenario could thus be that PM Renzi remains in power even in the case of a defeat. Yet another alternative scenario could foresee Prime Minister Renzi stepping down and a new PM being appointed without new elections. Either way, a defeat in the referendum would likely heighten policy uncertainty, not least because the 5-Star Movement has become a main challenger to Renzi’s PD in recent opinion polls, notably after the UK referendum.

New elections right after a ‘No’ vote look less likely, given that the new electoral law (Italicum) applies only to the lower house (Chamber of Deputies) – it was passed in the expectation that the reform of the Senate would proceed. Any government after a ‘No’ vote will thus likely be occupied with adapting the respective electoral laws for the next election.

Implications of a ‘No’ vote a risk to Italian bond spreads

Opinion polling ahead of the constitutional referendum remains finely balanced and the associated implications of a ‘No’ vote continue to present a risk to Italian bond spreads. Our expectation of core euro area yields rising gradually over the next few months (supported by upcoming base effects and potential tweaks to the ECB’s QE programme), combined with the fact that the 10yr Italy-Germany spread is close to our year-end target of 125bp, implies a gradual rise in 10yr Italian yields to 1.45% by end-2016. If a ‘Yes’ vote were to materialise, we would expect 10yr Italy-Germany spreads to initially tighten by 5-10bp. Meanwhile, a ‘No’ vote at the upcoming referendum is likely to result in 10yr Italy-Germany spreads widening to over 155bp. The political backdrop in Spain is currently more favourable than in Italy, and we maintain our preference of being long 10yr Spain versus Italy. We also recommend hedging against a potential escalation of Italian risks by selling 10yr Italy versus US Treasuries (targeting 0bp).

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