Deutsche Bank Restores Confidence

Global bankers learned at least one an important lesson from 2008 - when confidence starts to erode, survival depends on your ability to swiftly restore it.

Shares in Deutsche Bank (DB) rebounded by more than 20% this week as the troubled bank took a series of steps to reassure investors about its financial health. First, news of "discreet talks" between the German government and U.S. authorities regarding Deutsche Bank's legal troubles were somehow leaked by "sources in Berlin." The German government had previously denied involvement in the case, but now appears to be brokering a quick deal to prevent the need for state aid.

Next, "people with knowledge of the matter" moved to reset expectations about the ultimate size of the fine. This Summer, U.S. Department of Justice officials working on the case reportedly expected the DB settlement to end up in the $2-3 billion range based on precedents in similar cases involving Morgan Stanley, which agreed to a $2.6 billion fine in February, and Goldman Sachs, which reached a $5.1 billion deal in April. The DoJ often throws out larger numbers to begin a negotiation, but those inflated figures hardly ever become public. The leak of the proposed $14 billion settlement both alarmed Deutsche Bank investors and painted the DoJ into a corner. The latter will likely be the one to bite the bullet, accept a lower settlement and come off looking weak.

Deutsche Bank has a series of other ongoing legal issues -- including money-laundering charges related to its Russian operations and collusion with Monte dei Paschi to hide the Italian lender's losses - but has set aside $5.5 billion euros ($6.1 billion) for litigation. Any penalties beyond that would require the bank to raise capital. Management is reportedly preparing for that scenario, too.

Bloomberg reported Deutsche Bank is in talks about selling additional shares and disposing of assets at the same time the DoJ fine is announced. The firm could raise 5 billion euros worth of new equity without shareholder approval and is weighing a potential IPO of its asset management unit.

Fundamentally Deutsche Bank stands on fairly solid footing, but with high leverage and a balance sheet full of opaque Level 3 assets, the perception of panic could become the greatest enemy. Company management and government officials moved swiftly to restore short-term confidence this week, but it remains to be seen if the company can effectively remake its business identity

"Hard Brexit" Talk Pushes Pound to Multi-Decade Low

British leaders are talking up the possibility of a "hard Brexit," and it's starting to rattle global markets.

The British pound plummeted more than 6% in a two-minute span Friday morning during early Asia trading, hitting a 31-year low. Traders blamed the "flash crash" on a "fat finger" trade exacerbated by jumpy algorithms at a time of day when liquidity is sparse. The only problem with that story is during the rest of the session - after algorithms calmed down and humans had ample opportunity to seize the opportunity to buy lower - the pound didn't recover all of its losses. By the close of trading Friday, the sterling had fallen around 1.5%, bringing its losses for the week to more than 4%.

The pound's latest leg down is largely due to a shift in rhetoric among British officials toward talk of a "hard Brexit," meaning they will not compromise on immigration issues in order to maintain full access to the European single market. Most notably, British Prime Minister Theresa May struck an alarmingly populist, nativist tone in a speech to the Tory Party conference Wednesday. Tories are the pro-business politicians in the U.K., and their prioritization of social issues over economic ones sent shockwaves through European capital markets. Prior to this week there had been expectations the new conservative leadership would fight tooth and nail for a sweetheart Brexit deal, but with German Chancellor Angela Merkel saying the U.K. cannot maintain full access to the EU's internal market if it does not accept the EU's principle of free movement of people, Prime Minister May and Co. have made it clear they will draw a hard line under immigration issues.

Meanwhile, the leading voice of Italy's main opposition party wants to set a precedent by giving the U.K. an easy Brexit deal - conceivably to pave the way for a similar "Italeave" scenario in the not-too-distant future.

If the U.K. does choose to leave the European single market, the country's financial sector would be the biggest loser. A report prepared by Oliver Wyman on behalf of TheCityUK lobby group estimates a "hard Brexit" could cost U.K. financial institutions almost 40 billion pounds in lost revenue and 75,000 jobs.

While the pound was slipping this week, the Euro was strengthening following a Bloomberg report stating the European Central Bank (ECB) had discussed tapering asset purchases before the conclusion of its current quantitative easing (QE) program in March 2017. ECB media officer Michael Steen tweeted a denial of the report Tuesday, but it did little to temper the pound's move. The report also helped spur the latest reversal in European bond prices. The German 10-year bund, which just two weeks ago was trading at -0.15%, closed Friday back in positive territory.

The sensitivity of markets to any news about QE tapering is a reminder of their addiction to monetary easing. Bill Gross this week, in his always-colorful monthly investor letter, compared compulsively interventionist central bankers to "Martingale gamblers" who double their bet after every loss - only they don't have the unlimited bankroll needed for such a strategy to be riskless.

Global markets initially recoiled after Brexit based on pure shock and uncertainty. But once the hysteria died down and it seemed the U.K. would 1) take its time with the breakup, and 2) prioritize ongoing access to the European single market, European economic data and financial markets swiftly recovered. Now, however, fears about Brexit are beginning to re-emerge. Prime Minister May has stated her intention to invoke Article 50 around March of next year, and the resultant deal looks increasingly likely to be a hostile one. How much of her shift in tone is simply posturing ahead of negotiations with the EU? We should get some indication over what could be a skittish next six months for global markets.

Solid U.S. Economic Data Keeps Fed on Track for December Hike

Economic data in the U.S. this week did nothing to derail the Fed's plan to hike interest rates in December.

The U.S. economy added 156,000 jobs in September, falling narrowly short of consensus expectations for 172,000 new non-farm payrolls. The unemployment rate ticked up to 5% as more discouraged workers re-entered the labor force. Average hourly earnings grew by a modest 0.2%, bringing 12-month growth to a respectable 2.6%.

Earlier in the week, the Institute for Supply Management (ISM) survey exceeded even the most bullish expectations by rebounding to 57.1, the highest reading in 11 months. The upbeat indication of strong U.S. manufacturing activity followed August's reading of 51.4, which was the lowest in six years. The U.S. also posted surprise growth in factory orders for August, which rose 0.2% against expectations for 0.2% decline.

The implied odds for a December hike grew to 65% this week in response to the solid economic data. Even the most dovish Fed President, Chicago's Charles Evans, acknowledged the central bank is likely to raise rates before the end of the year. It was less surprising to hear notorious hawk Jeffrey Lacker of the Richmond Fed urge the central bank to "be preemptive like 1994" to head off any potential wave of inflation. If Lacker had his way, the Fed Funds rate would already be at 1.5%.

If the Fed held off hiking rates over Brexit uncertainty, it's difficult to understand why they're so confident in hiking rates amid rising odds of an acrimonious breakup between the U.K. and EU. But with economic data remaining firm and the likely outcome of the U.S. election coming into greater focus, December is looking more and more like a formality.

Supreme Court Hears First Insider Trading Case in 20 Years
The Supreme Court this week heard its first insider trading case in 20 years - Salman v. the United States. Bassam Salman, a grocery wholesaler from Chicago, profited from a series of trades in biotechnology stocks based on corporate secrets shared by his brother-in-law, a healthcare investment banker in California. While such activity may seem blatantly illegal, there are holes in securities laws and legal precedents that prevent the case from being a slam dunk.

In a 1983 case, Dirks v. the SEC, the Supreme Court ruled illegal tipping required evidence of "personal benefit" stemming from a quid pro quo arrangement between the person sharing the information and the person trading on it. The issue in the Salman case is whether passing along tips to a family member who then profits from related trades meets that "personal benefit" standard.

Based on early testimony, the court appears to be exasperated by the case but leaning toward ruling on behalf of the government in order to maintain the basic integrity of financial markets. However, several justices have made it clear the same "personal benefit" argument may not be compelling if the case did not involve family members. For more casual relationships, prosecution would be difficult. That's because In December 2014 the U.S. Court of Appeals for the Second Circuit of Manhattan undermined several recent and ongoing insider trading cases by overturning the conviction of two hedge fund managers charged with profiting from information passed through a chain of tippees. In Newman v. the United States, the court found insufficient evidence the defendants were aware of any benefit provided to the tippers, a requirement to prove a violation. The Supreme Court declined to hear the appeal. During argument in the Salman case, Chief Justice John Roberts asked Deputy Solicitor General Michael Dreeben, regarding the personal benefit standard: "It's kind of a hazy line to draw, isn't it?"

If the Supreme Court does rule, as expected, in favor of the government, it will be need to pen a very technical majority opinion that avoids rewriting securities laws in a way that goes beyond its enumerated powers. Fixing the underlying problem will be up to Congress, and in today's political climate when and if that happens is anyone's guess.