Euro strong as Ukraine crisis develops

The EUR/USD has had a steady uptrend since Feb.  Analysis of any sanctions against Russia suggest that the US or the EU may be more negatively impacted.  For the time being, EUR/USD seems to be getting a boost from real money flows - as concerned parties sell their USD for EUR.  But how long with that last?  If the EU is a net loser of this situation, be it from sanctions, or the close proximity to Ukraine, it will certainly put pressure on the Euro.  But if Russia and China retaliate, the US would feel the most economic pressure (for example by Russia/China dumping USD on the market).  These opposing pressures will make it difficult for EUR/USD to have a clear direction in the coming months as the crisis unfolds.  Also, volatility can be expected in any Euro or US Dollar denominated pair, if any significant actions are taken by a state (such as China flooding the market with USD which they have in large supply).  See the below daily EUR/USD chart:

Daily EUR/USD 

Russia’s $160 Billion Stick Hinders Crimean Sanctions

As U.S. and European officials began imposing sanctions in their face-off with Russia over Ukraine, Vladimir Putin’s $160 billion in oil and natural gas exports may be his most potent weapon to limit punitive measures.

The U.S. and its European allies have few levers to deter Putin even as they warn Russia not to annex Crimea after a referendum in Ukraine’s southern region yesterday. The European Union today imposed travel-visa bans and assets freezes on 21 individuals and President Barack Obama issued an executive order naming seven Russians for sanctions.

Russia, the world’s largest oil producer, exported $160 billion worth of crude, fuels and gas-based industrial feedstocks to Europe and the U.S. in 2012. While shutting the spigot on Russian energy exports would starve the Moscow government of essential flows of foreign cash, the price may be too high for European consumers and it may not alter Putin’s plans, said Jeff Sahadeo, director of Carleton University’s Institute of European, Russian and Eurasian Studies.

Related:

• Putin Is No Mad Man to Russians as Power Play Trumps Economy
• Obama Imposes Sanctions on Seven Top Russians After Crimea Vote
• EU Adopts Sanctions on Russians After Crimea Referendum
• Ukraine’s Culture Is Bloody, Splendid and Chekhovian
• West Warns Russia Not to Annex Crimea After Referendum
• Opinion: Sanction Russia? Reagan Tried It With No Luck

“In the short term, this would be very difficult to do and it’s not clear it would even affect Russian behavior,” Sahadeo said in a phone interview from Ottawa. If the West “puts down the card of energy sanctions, it becomes a question of who blinks first.”

Economic Pain

German Chancellor Angela Merkel, leader of the European Union’s biggest economy, said last week her nation is prepared to bear the economic pain that would accompany Russian retaliation to any sanctions.

“If Russia continues to interfere in Ukraine, we stand ready to impose new sanctions,” Obama said in a press conference today.

Analysts from Goldman Sachs Group Inc., Bank of America Corp. and Morgan Stanley said Europe probably won’t back sanctions that limit flows of Russia’s oil and gas. European members of the Paris-based International Energy Agency imported 32 percent of their raw crude oil, fuels and gas-based chemical feedstocks from Russia in 2012.

Collectively, the EU, Turkey, Norway, Switzerland and the Balkan countries got 30 percent of the natural gas they burned from Russia last year, much of it pumped through pipelines that cross Ukrainian territory, according to the U.S. Energy Department in Washington.

Failed Attempt

Abstaining from Russian oil and gas would be “off the table” for Europe, said Marc Lanthemann, Eurasia analyst with Stratfor, a geopolitical intelligence company based in Austin, Texas. Europe risks a replay of its failed attempt six years ago to punish the Kremlin for going to war with the Republic of Georgia, when it was unable to impose sanctions after acknowledging its dependence on Russian energy.

“We’re not expecting sanctions with many teeth coming through,” Lanthemann said.

While the ruble, Ukrainian hryvnia and other regional currencies have tumbled as the conflict escalated, global oil markets aren’t reacting to the potential for a sanctions-induced supply disruption.

Brent crude futures traded in London, the benchmark for more than half the world’s oil, traded at $107 a barrel today, a decline from March 3, after Russia’s Parliament approved the use of its military in Ukraine.

U.K. gas for next month, the EU’s benchmark contract traded on ICE Futures Europe, fell 1 percent to 58.44 pence a therm at 2:57 p.m. London time, down from 61.70 pence on March 3.

‘Counterproductive Instrument’

Crimea, a dominion of Russia and then the Soviet Union for more than two centuries before the Communist empire collapsed in 1991, voted yesterday to join Russia. The plebiscite was called after a popular uprising forced Russian-backed President Viktor Yanukovych to flee the Ukrainian capital of Kiev last month.

“Our partners understand that sanctions are a counterproductive instrument,” Russian Foreign Minister Sergei Lavrov told reporters after meeting with U.S. Secretary of State John Kerry on March 14.

The U.S. and Europeans will likely disagree over any energy sanctions and how much should be curtailed, said Seva Gunitsky, an assistant professor at the University of Toronto’s Munk School of Global Affairs.

Sanction Traction

“In order to get any traction with sanctions you have to bring the EU in and I think that will be a difficult task because of their dependence on Russian oil and gas resources,” Gunitsky said.

The EU’s bill for Russian oil and gas amounted to $156.5 billion in 2012, 38 times what the U.S. spent for Russian energy, according to the International Trade Centre’s Trade Map, a venture sponsored by the World Trade Organization and the United Nations.

Sanctions that crimp the lifestyles of Putin’s billionaire friends, such as visa restrictions and bank account freezes, might “be more effective and easier for Europe to stomach than sanctions on Russian gas,” Gunitsky said.

And energy sanctions may backfire if cutting off Russian shipments raises prices and triggers a backlash from angry European consumers.

“The sanctions might hurt the current customers of Russia at least as much as they hurt Russia,” said Judith Dwarkin, chief energy economist at ITG Investment Research in Calgary. “It’s a double bind. The European market is very important for Russia and Russia is very important for the European market.”

http://www.bloomberg.com/news/print/2014-03-17/russia-s-160-billion-stick-hinders-crimean-sanctions.html

Russia 'planned Wall Street bear raid'

There is a cynicism in the relationship between Russia and the US, being played out in the Crimean crisis, which is deep, rooted in history and shows that the triumph of capitalism over communism wasn't the end of the power game between these two nations.

The depth of mistrust between the two was highlighted in the interview given by Hank Paulson, the former US treasury secretary, for my recent BBC Two documentary, How China Fooled The World.

The excerpts I am about to quote never made it into the film, because they weren't relevant to it. But they give a fascinating understanding of the complex relationship between Washington and Moscow.

Mr Paulson was talking about the financial crisis of the autumn of 2008, and in particular the devastation being wreaked on Fannie Mae and Freddie Mac, the two huge underwriters of American mortgages - huge financial institutions that had a funny status at the time of being seen by investors to be the liability of the US government, which in legal reality were not exactly that.

“Start Quote

This person told me that the Chinese had received a message from the Russians which was, 'Hey let's join together and sell Fannie and Freddie securities on the market'”

Here is Mr Paulson on the unfolding drama:

"When Fannie Mae and Freddie Mac started to become unglued, and you know there were $5.4tn of securities relating to Fannie and Freddie, $1.7tn outside of the US. The Chinese were the biggest external investor holding Fannie and Freddie securities, so the Chinese were very, very concerned."

Or to put it another way, the Chinese government owned $1.7tn of mortgage-backed bonds issued by Fannie Mae and Freddie Mac, and it was deeply concerned it would incur huge losses on these bonds.

Mr Paulson: "I was talking to them [Chinese ministers and officials] regularly because I didn't want them to dump the securities on the market and precipitate a bigger crisis.

"And so when I went to Congress and asked for these emergency powers [to stabilise Fannie and Freddie], and I was getting the living daylights beaten out of me by our Congress publicly, I needed to call the Chinese regularly to explain to the Central Bank, 'listen this is our political system, this is political theatre, we will get this done'. And I didn't have quite that much certainty myself but I sure did everything I could to reassure them."

In other words, China had lent so much to the US that Mr Paulson needed to do his best to persuade its government and central bank that China's investment in all this US debt would not be impaired.

Now this is where we enter the territory of a geopolitical thriller. Mr Paulson:

"Here I'm not going to name the senior person, but I was meeting with someone… This person told me that the Chinese had received a message from the Russians which was, 'Hey let's join together and sell Fannie and Freddie securities on the market.' The Chinese weren't going to do that but again, it just, it just drove home to me how vulnerable I felt until we had put Fannie and Freddie into conservatorship [the rescue plan for them, that was eventually put in place]."

For me this is pretty jaw-dropping stuff - the Chinese told Hank Paulson that the Russians were suggesting a joint pact with China to drive down the price of the debt of Fannie and Freddie, and maximize the turmoil on Wall Street - presumably with a view to maximizing the cost of the rescue for Washington and further damaging its financial health.

Paulson says this guerrilla skirmish in markets by the Russians and Chinese didn't happen.

But this kind of intelligence from China on Russian desire and willingness to embarrass the US in a financial sense may help to explain - in a small way - why President Obama shows little desire to understand Crimea as seen by Mr Putin.

And maybe if the US is being a bit more robust than the EU in wanting to impose economic and financial sanctions on Russia, that may not all be about America's much lesser dependence (negligible dependence) on Russian gas and oil.

http://www.bbc.com/news/business-26609548 

The Russians Have Already Quietly Pulled Their Money From The West

Earlier today we reported that according to weekly Fed data, a record amount - some $105 billion - in Treasurys had been sold or simply reallocated (which for political reasons is the same thing) from the Fed's custody accounts, bringing the total amount of US paper held at the Fed to a level not seen since December 2012. While China was one of the culprits suggested to have withdrawn the near USD-equivalent paper, a far likelier candidate was Russia, which as is well-known, has had a modest falling out with the West in general, and its financial system in particular. Turns out what Russian official institutions may have done with their Treasurys (and we won't know for sure until June), it was merely the beginning. In fact, as the FT reports, in silent and not so silent preparations for what will be near-certain financial sanctions (which would include account freezes and asset confiscations following this Sunday's Crimean referendum) the snealy Russians, read oligarchs, have already pulled billions from banks in the west thereby essentially making the biggest western gambit - that of going after the wealth of Russia's 0.0001% - moot.

From the FT:

Russian companies are pulling billions out of western banks, fearful that any US sanctions over the Crimean crisis could lead to an asset freeze, according to bankers in Moscow.

Sberbank and VTB, Russia’s giant partly state-owned banks, as well as industrial companies, such as energy group Lukoil, are among those repatriating cash from western lenders with operations in the US. VTB has also cancelled a planned US investor summit next month, according to bankers.

The flight comes as last-ditch diplomatic talks between Russia’s foreign minister and the US secretary of state to resolve the tensions in Ukraine ended without an agreement.

Markets were nervous before Sunday’s Crimea referendum on secession from Ukraine. Traders and businesspeople fear this could spark western sanctions against Russia as early as Monday.

It probably will. What it will also do is force Russia to engage China far more actively in bilateral trade and ultimately to transact using either Rubles or Renminbi, and bypass the dollar. Perhaps even using gold, something which the price of the yellow metal sniffed out this week, pushing itself to 6 month highs. It will also make financial ties between the two commodity-rich nations even closer, while further alienating that "imperialist devil," the US.

Of course, the west thinking like the west, and assuming that all that matters to Russia is the closing level of the Micex, believes that a sufficient plunge in Russian stocks would have been enough to deter Putin. After all, the only thing everyone in the US cares about is if the S&P 500 closed at yet another all time high, right?

What the west didn't realize, as we predicted a month ago, for Putin it is orders of magnitude more important to have the price of commodities, primarily crude and gas, high than seeing the illusion of paper wealth, aka stocks, hitting all time highs. Especially since in Russia an even smaller portion of the population cares about the daily fluctuations of the stock market. As for the oligarchs, if there is someone who will be delighted to see their power, wealth and influence impacted adversely, if only for a short period of time, it is Vladimir Vladimirovich himself, whom the west misjudged massively once more. Not to mention that the general population will be even more delighted, and boost Putin's rating even higher, if these crony billionaires are made to suffer by the west, if only a little.

(Here we would be remiss not to comment on his easy it supposedly is for Obama to freeze the assets of a few corrupt Russian billionaires, and yet the very proud Americans who nearly brought the entire financial system to the brink in 2008, are now richer than ever.)

In the meantime, some of Russia's oligarchs are effectively welcoming the challenge. Bloomberg reports:

Alisher Usmanov, the country’s richest person, controls his most valuable asset, Metalloinvest Holding Co., Russia’s largest iron ore producer, through three subsidiaries, one of which is located in Cyprus, an EU member nation. The 60-year-old also owns a Victorian mansion in London that he bought in 2008 for $70 million, according to a May 18, 2008, Sunday Times newspaper report. He’s lost $1.5 billion since the crisis began, according to the Bloomberg ranking.

“We are concerned with the possible sanctions against Russia but don’t see any dramatic repercussions for our business,” Ivan Streshinsky, CEO at USM Advisors LLC, which manages Usmanov’s assets, including stakes in Megafon OAO and Mail.Ru Group Ltd., said in an interview at Bloomberg’s offices in Moscow today.

“Mail.Ru and Megafon revenue is coming from Russia and people won’t stop making calls and using the Internet,” he said. “Metalloinvest may face closure in European and American markets, but it can re-direct sales to China and other markets.”

Great job, Obama: you just pushed Russia and China even closer by necessity! Furthermore, it should come as no surprise that while Russians were pulling their money from the west, western firms were getting out of Dodgeski.

One senior Moscow banker said 90 per cent of investors were already behaving as if sanctions were in place, adding that this was “prudent exposure management”.

These moves represent the flipside of the more obvious withdrawal of western money from Russian markets that has been evident over the past fortnight.

Traders and bankers said US banks had been particularly heavy sellers of Russian bonds. According to data from the Bank for International Settlements, US banks and asset managers between them have about $75bn of exposure to Russia.

Joseph Dayan, head of markets at BCS, one of Russia’s largest brokers said: “It’s been quite an ugly picture in Russian bonds the last few days and some of it has to do with international banks reducing exposure.”

Although foreign banks have not yet begun cutting credit to Russian companies en masse, bankers said half a dozen live deals to fund some of Russia’s biggest companies were in limbo as lenders waited to see how punitive western sanctions would be.

So the bottom line is that Russia, thinking a few steps ahead, already has withdrawn the bulk of its assets from the West, and why not. Recall that a year ago it was revealed that the same Russians who were supposed to be punished in Cyprus had mostly withdrawn their funds in advance of the bail in: they tend to know what is coming. It was the ordinary Cypriot citizens, who had done nothing wrong, who were most impaired.

And so while the Russian response is already known, we wonder just how true is the inverse: just how prepared is the west, and especially Europe, to exist in a world in which a third of Germany's gas is suddenly cut off? We can't wait to find out early next week.

http://www.zerohedge.com/news/2014-03-14/russians-have-already-quietly-pulled-their-money-west

The Tanks Are Coming While Russia, US "Remain At Odds" Over Ukraine

With Interfax reporting that Belarus has begun full-scale military drills in a "readiness check", images from Russia and Ukraine suggest the worst-case scenario - that Russia is making preparations to invade Ukraine, not just Crimea but perhaps as far west as Kharkiv, or even beyond - is more possible. Talks have broken down:

• *LAVROV SAYS RUSSIA, U.S. REMAIN AT ODDS ON UKRAINE: INTERFAX
• *LAVROV SAYS RUSSIA TO RESPECT `WILL' OF CRIMEAN PEOPLE

Russia now has a massive force of tanks, troops, artillery, aircraft, and naval forces in position to potentially invade mainland Ukraine from Crimea in the south, but also from positions east and north of Ukraine.

Lavrov adds:

• *LAVROV SAYS RUSSIA TO RESPECT CHOICE MADE AT CRIMEAN REFERENDUM
• *LAVROV SAYS KERRY `DIDN'T THREATEN RUSSIA WITH ANYTHING'
• *LAVROV SAYS WESTERN SANCTIONS WOULD BE COUNTERPRODUCTIVE

And subtley poitning out the hypocrisy:

• RUSSIA'S LAVROV SAYS IF KOSOVO WAS A SPECIAL CASE THEN CRIMEA SHOULD BE A SPECIAL CASE TOO

Then Lavrov said this:

• RUSSIA HAS HAD AND CAN HAVE NO PLANS TO INVADE SOUTHEAST OF UKRAINE - LAVROV

Which seems to run counter to the following images pouring in from across Russia of even more firepower on the move.

And images suggest more to come...

And finally:

• *LAVROV SAYS `EVERYONE UNDERSTANDS WHAT CRIMEA MEANS FOR RUSSIA'

Which we suspect is why all the tanks are rolling

http://www.zerohedge.com/news/2014-03-14/russia-us-remain-odds-over-ukraine-sanctions-counterproductive-and-tanks-are-coming

Crimea Bank Runs Begin As "Bail-In" Risks Arise

While the sight of Russian flags, pro-Russian troops, and Russian navy ships in Crimea is now a day-to-day thing; this morning brings a new normal for the eastern Ukraine region - long lines at bank ATMs as the bank runs have begun. We noted last night the dreaded inversion of Ukraine's yield curve, the greater-than-50% yields on 3-month Ukraine government debt, and the pressures on local bank debt maturities as the ability to garner dollars cost-effectively was becoming a problem but on the heels of concerns by the head of the central bank that moving cash in Crimea was difficult, ATM withdrawal limits have been cut. People in long ATM lines are reported to be concerned because "banks are closing" but it is Deutsche Bank's comments this morning that raised many an eyebrow as they suggest that Ukraine's debt is pricing in a "burden-sharing" haircut for bondholders (which as we have seen in the past - in Cyprus - can quickly ripple up the capital structure and become a depositor haircut).

Quiet calm bank runs are beginning in Ukraine...

h/t @MarquardtA

As Deutsche Bank raises the prospect of bail-ins and Private-Sector-Involvement (PSI) in bailing-in the banks and government...

...given the recent experience of IMF programs it is natural to ask whether some form of 'private sector involvement' (PSI) will be proposed as part of any package of support.

The IMF itself recently published a consultation paper arguing that private sector debt restructurings had “often been too little, too late” and that the fund should look at ways to avoid its “resources eing used simply to bail out private creditors”. The ongoing consultation process which this paper nitiated is one reason why concerns over IMF-sponsored restructuring are more prevalent for Ukraine now than they have been in similar situations in the past. However, we think it unlikely that there will be  ignificant change in the Fund’s approach towards Ukraine, given that the consultation is still ngoing, views are divided and its outcome remains uncertain. Nevertheless, that does not mean that some form of PSI will not be considered, condoned, encouraged or even mandated and so it is useful to onsider the pros and cons from the perspective of the Ukraine (and its potential official sector inanciers) and the implications for private sector creditors.

[Of course PSI can take on many forms from debt-extensions to bondholder haircuts to further up the capital structure depositor haircuts]

...current market prices are relatively consistent with such a scenario of PSI-lite. Indeed, the current relative pricing of Ukrainian bonds are very unusual: the pricing of short-dated bonds are distressed, implying a relatively high probability that they won’t redeem at par, but on the other hand the narrow range of prices across the curve suggests that the market assumes a high recovery in the event of a default/restructuring.

Such pricing would be fair, considering a baseline scenario involving an IMF program and an orderly adjustment. However, it leaves little compensation for a more disorderly scenario. Tensions with Russia show no sign of abating and could escalate further. Also there is no guarantee that the new government has a strong enough popular mandate to carry through the necessary reforms. PM Yatseniuk has emphasized that the road ahead for Ukraine will not be easy, but only time will tell how united the country will be in following the path he intends to take.

We suspect a brand new populist PM is unlikely to remain in power long if depositor haircts were engaged - and would certainly not imbibe the eastern Ukraine region with the country's new leader.

It is also notable that these bank runs are focused on local Ukraine/Russian banks...

http://www.zerohedge.com/news/2014-03-13/crimea-bank-runs-begin-bail-risks-arise

Trader kills self in finance world’s latest suicide

A Manhattan trader was killed Tuesday morning by a speeding Long Island Rail Road commuter train, marking at least the seventh suicide of a financial professional this year.

Edmund (Eddie) Reilly, 47, a trader at Midtown’s Vertical Group, jumped in front of an LIRR train at 6 a.m. near the Syosset train station.

He was declared dead at the scene.

Reilly’s identity was confirmed by Salvatore Arena, an LIRR spokesperson, who said an investigation into the incident was continuing.

Passengers on the west-bound express train told MTA investigators they saw a man standing by the tracks before he jumped in front of the train, Arena said.

“Eddie was a great guy,” Rob Schaffer, a managing director at Vertical, told The Post in an email. “We are very upset and he will be deeply missed.”

The divorced father of three had rented a house around the corner from his ex-wife, Michelle Reilly, in East Norwich, NY.

One family friend, who said he spoke to the trader on Sunday, told The Post that Reilly “didn’t look good.”

Separately:

■  Autumn Radtke, the CEO of First Meta, a cyber-currency exchange firm, was found dead on Feb. 28 outside her Singapore apartment. The 28-year-old American, who worked for Apple and other Silicon Valley tech firms prior to founding First Meta, jumped from a 25-story building, authorities said.

■  On Feb. 18, a 33-year-old JPMorgan finance pro leaped to his death from the roof of the company’s 30-story Hong Kong office tower, authorities said. Li Junjie’s suicide marked the third mysterious death of a JPMorgan banker. So far, there is no known link between any of the deaths.

■  Gabriel Magee, 39, a vice president with JPMorgan’s corporate and investment bank technology arm in the UK, jumped to his death from the roof of the bank’s 33-story Canary Wharf tower in London on Jan. 28.

■  On Feb. 3, Ryan Henry Crane, 37, a JPM executive director who worked in New York, was found dead inside his Stamford, Conn., home. A cause of death in Crane’s case has yet to be determined as authorities await a toxicology report, a spokesperson for the Stamford Police Department said.

■  On Jan. 31, Mike Dueker, chief economist at Russell Investments and a former Federal Reserve bank economist, was found dead at the side of a road that leads to the Tacoma Narrows Bridge in Washington state, according to the Pierce County Sheriff’s Department. He was 50.

■ On Jan. 26, William Broeksmit, 58, a former senior risk manager at Deutsche Bank, was found hanged in a house in South Kensington, according to London police.

http://nypost.com/2014/03/12/trader-throws-self-in-front-of-train-in-finance-worlds-latest-suicide/?utm_campaign=SocialFlow&utm_source=NYPTwitter&utm_medium=SocialFlow

Almost Half a Billion Worth of Bitcoins Vanish

Mt. Gox, once the dominant exchange for bitcoin trading, on Friday said more than $470 million of the virtual currency vanished from its digital coffers, kicking into high gear a search for the missing money by victims and cybersleuths.

Mt. Gox Chief Executive Mark Karpelès said technical issues had opened the way for fraudulent withdrawals, though he didn't provide details.Acting alone and in groups, the people stepped up their efforts after Mt. Gox filed for bankruptcy protection in Japan and confirmed rumors it had lost almost 750,000 of its customers' bitcoins, as well as roughly 100,000 of its own.

"There was some weakness in the system, and the bitcoins have disappeared. I apologize for causing trouble," Mr. Karpelès said at a packed news conference at a Tokyo courthouse after the bankruptcy filing.

The disappearance underscores the risks of currencies that exist only online and aren't backed by a central bank. Mt. Gox wasn't overseen by national regulators, so there is no entity to step in and back investors' deposits.

Read full article here - Open a Forex Account

China Currency Plunges Most In Over 5 Years, Biggest Weekly Loss Ever: Yuan Carry Traders Crushed

And just like that the Chinese yuan devaluation has shifted away from the merely "orderly."

In the past few hours of trading, China, which as we reported two days ago has started intervening aggressively in the Yuan market (for the reasons why, read this), has seen its currency crash by nearly 0.9%, which may not seem like much, but is in fact the largest drop since December of 2008, and at last check was trading at around 6.18, even as the PBOC fixed the CNY reference rate 0.02% higher from the last official close to 6.1214, erasing pivot support point at 6.1346 and 6.1408.  Naturally this means that the obverse, the CNYUSD, has crashed to as low as 0.1620. Should this move sustain without reverting, this will be the biggest weekly loss ever!

The dramatic monthly plunge from the CNY perspetive is shown on the chart below.

There isn't much commentary on this most recent dramatic move aside from this commenbt by Zhou Hao, a Shanghai-based economist at ANZ, who said "CNY movements indicate that the authorities are determined to deter capital inflows and there were likely stop-losses triggered when the CNY broke key psychological levels."

What is more notable is that the move, while certainly intending to shake out the carry traders bent on riding the USDCNY ever lower, is starting to appear borderline erratic. As a reminder, and as we posted yesterday before the FT picked up the story earlier today, there is a lot of pain in store for those betting on a stronger Yuan, because while the move may not seem dramatic (by USDTRY standards), the reality is that the carry trade positions have massive leverage associated with them, with the pain level on $500 billion in existing carry trades beginning to manifest once the Yuan enters the 6.15-6.20 gap and becomes acute once the European Knock-In zone of 6.20 is crossed (see first chart below) and rising exponentially from there. In fact as we explained, should the renminbi break past 6.20 per dollar, which it is very close to right now, banks would be forced to call in collateral, accelerating the Yuan plunge, at which point the drop would become self-sustaining. The pain from that point on is around US$4.8 billion in total losses for every 0.1 above the average EKI (see third chart).

This is what we warned yesterday:

The total size of the carry trade is hard to estimate although even just looking at some of the onshore CNY positions accumulated, DB Asia FX strategist Perry Kojodjojo estimates that corporate USD/CNY short positions are around $500bn. The size of the carry trade and the fact that China saw significant capital outflows during the last period of substantial Renminbi depreciation in the summer of 2012 has led to concerns over what this might mean for both the Chinese economy and financial markets as well as broader global financial implications.

Morgan Stanley believes that one such carry-trade structured product that will be the "pressure point" for this - should the Yuan continue to depreciate - is the Target Redemption Forward (TRF) which has a payoff that looks as follows...

While this is just an example of a product payoff matrix to the holder, the broader point is that the USD/CNH market has a particular level (or range of potential levels) at which three factors can create non-linear price action. These are:

1. Losses on TRF products will (on average) crystallize if USD/CNH goes above a certain level. This has implications for holders of TRF products, who are mostly corporates;

2. The hedging needs of writers of TRF products (banks) mean that there is a point of maximum vega for banks in USD/CNH. Below this level banks need to sell USD/CNH vol; above this level banks need to buy USD/CNH vol;

3. The delta-hedging needs of banks are complex. As we approach the average strike (the 6.15 in the theoretical point of Exhibit 1), banks need to buy spot USD/CNH. Above this point but below the European Knock-in (EKI) (i.e., between 6.15 and 6.20 in Exhibit 1), banks need to sell spot. Then above the EKI, banks don’t need to do anything in spot.

From internal Morgan Stanley data, we estimate that the point of maximum vega is somewhere in the range of 6.15-6.20, and that the 6.15-6.20 in Exhibit 1 is reasonably indicative of the average strikes and EKIs in the market.

In other words, so long as the TRF products remain in place (i.e., are not closed out) and we remain below the maximum vega point (somewhere between 6.15 and 6.20), there is natural selling pressure by banks in USD/CNH vol.When we get above that level, there is natural vol buying pressure.

Of course, in the scenario that USD/CNH keeps trading higher and goes above the average EKI level, the removal of spot selling flow by banks and the need to buy vol means the topside move may accelerate.

Simply put, if the CNY keeps going (whether by PBOC hand or a break of the virtuous cycle above), then things get ugly fast...

How Much Is at Stake?
In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013.

Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains.

Taking that as a base case, we can then estimate the size of potential losses to holders of these products if USD/CNH keeps trading higher.

In round numbers, we estimate that for every 0.1 move in USD/CNH above the average EKI (which we have assumed here is 6.20), corporates will lose US$200 million a month. The real pain comes if USD/CNH stays above this level, as these losses will accrue every month until the contract expires. Given contracts are 24 months in tenor, this implies around US$4.8 billion in total losses for every 0.1 above the average EKI.

Deutsche Bank concludes...

Looking forward it’s possible that the PBOC is not attempting to actively engineer a sustained depreciation of the Renminbi but rather is attempting to increase the level of two-way volatility in the market to discourage the carry trade and also excessive capital inflows. In terms of the broad risk going forward the sheer scale of the challenge the PBOC has set out to tackle likely means they will have to move with restraint. This is certainly a story to watch...

As Morgan Stanley warns however, this has much broader implications for China...

The potential for US$4.8 billion in losses for every 0.1 above the average EKI could have significant implications for corporate China in its own right, as could the need to post collateral on positions even if the EKI level is not breached.

However, the real concern for corporate China is linked to broader credit issues. On that, it’s worth reiterating that the corporate sector in China is the most leveraged in the world. Further loss due to structured products would add further stress to corporates and potentially some of those might get funding from the shadow banking sector. Investment loss would weaken their balance sheets further and increase repayment risk of their debt.

In this regard, it would potentially cause investors to become more concerned about trust products if any of these corporates get involved in borrowing through trust products. In this regard, this would raise concerns among investors, given that there is already significant risk of credit defaults to happen in 2014.

Remember, as we noted previously, these potential losses are pure levered derivative losses... not some "well we are losing so let's greatly rotate this bet to US equities" which means it has a real tightening impact on both collateral and liquidity around the world... yet again, as we noted previously, it appears the PBOC is trying to break the world's most profitable and easy carry trade - which has created a massive real estate bubble in their nation (and that will have consequences).

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The bottom line is the question of whether the PBOC's engineering this CNY weakness is merely a strategy to increase volatility and thus deter carry-trade malevolence (in line with reform policies to tamp down bubbles) OR is it a more aggressive entry into the currency wars as China focuses on its trade (exports) and keeping the dream alive? (Or, one more thing, the former morphs into the latter as a vicious unwind ensues OR the market tests the PBOC's willingness to break their momentum spirit).

It appears, as Bloomberg notes, the PBOC is winning: "Yuan has gone from being most attractive carry trade bet in EM to worst in 2 mos as central bank efforts to weaken currency cause volatility to surge. Yuan’s Sharpe ratio turned negative this yr as 3-mo. implied volatility in currency rose in Feb. by most since May, when Fed signaled plans to cut stimulus."

So far the PBOC's "shock and awe" has impressed currency traders. Hopefully, the PBOC knows what it is doing because if indeed it causes the carry trade to unwind, the unwind could send the currency plunging well beyond the central bank's intended limits. What happens then nobody knows.

Curious for more? Read our first post in this series: Welcome To The Currency Wars, China (Yuan Devalues Most In 20 Years)

Finally, if indeed this is the start of the real carry unwind, things go from bad to worse: read "The Pig In The Python Is About To Be Expelled": A Walk Thru Of China's Hard Landing, And The Upcoming Global Harder Reset

http://www.zerohedge.com/news/2014-02-27/chinese-currency-plunges-most-over-5-years-biggest-weekly-loss-ever-yuan-carry-trade