Raphael Stevens

Big deals rarely happen without big personalities. If Elon Musk were an uninteresting tycoon with a low public profile and a puritanical approach to promises, then shares in Twitter, a social-media platform, would be trading within a whisker of his $54.20 per share offer. The difference, or “spread”, between this offer and Twitter’s current trading price, of below $40, is a reminder that he is not. The wider the spread, the lower the chance investors assign to a deal completing. To Mr Musk and Twitter’s management, the spread is a live opinion poll in a fractious situation. But to a group of specialised hedge-fund managers, it is their bread and butter. Merger arbitrage, also known as risk arbitrage, involves purchasing the shares of a target firm during the risky interval between a deal’s announcement and its completion. The arbitrager first identifies a merger that the market is relatively gloomy about—ie, a spread that they believe overestimates the chance of a deal’s failure. Then they buy shares in the company, and wait until the deal closes and the acquirer pays the offered price per share. The amount of capital dedicated to this strategy has quadrupled during the past decade to more than $100bn, despite some patchy returns. For several reasons, its star will continue to rise. For a start, big deals are in plentiful supply. It is no coincidence that this strategy came of age during America’s buyout boom of the 1980s. After a white-hot 2021, more than 50 deals with a value exceeding $5bn have been announced so far this year. Companies’ balance-sheets are stocked with cash and tumbling valuations have created bargains. The arbitragers are not yet seeing any signs of recession. The deals themselves also need to have some controversy associated with them. Ideally, someone should be trying, and failing, to kill them. Here lies another tailwind: that regulators are in an interventionist mood. Corporate synergies are coming up against national-security and antitrust concerns. Shares in Avast, a Czech cyber-security firm, were edging towards the price offered by NortonLifeLock, its bigger American competitor, before Britain’s Competition and Markets Authority said it was taking a closer look at the deal in March. More than $1bn was wiped off the market value of a firm that was being bought for around $8bn. Arbitragers were not far behind: around a quarter of Avast’s stock is currently in the hands of hedge funds that bought only after the deal was announced. Warren Buffett, a celebrated investor who became an active and successful arbitrager early in his career, is returning to the action. In January Microsoft announced a blockbuster takeover of Activision Blizzard, a video-game developer. A gaping spread cause by internal strife and competition worries was enough to tempt Berkshire Hathaway, the conglomerate run by Mr Buffett, to increase its stake in the game-maker, to nearly 10%. Mr Buffett was already a shareholder. But some arbitragers have been known to screen investments by hiring translators, lawyers and even courtroom spies. The final bump comes from rising interest rates. Spreads are widened by an increase in the risk-free rate, since investors demand a higher rate of return for holding shares; those piling their capital into merger-arbitrage funds salivate at the thought of inflation-proof returns largely uncorrelated with the wider stockmarket. The catch is that not every merger is completed. “If the deal goes through, we make some money. And if the deal doesn’t go through, who knows what happens,” ruminated Mr Buffett recently. The “who knows” part is also now more complicated. The price shares would trade at following a deal’s collapse, a crucial determinant of the risk-reward calculation for an arbitrage strategy, becomes harder to assess when markets are volatile and valuations uncertain. But arbitragers have, at least, been given a heady cocktail of dealmaking, corporate complexity and rising rates. ■For exclusive insight and reading recommendations from our correspondents in America, sign up to Checks and Balance, our weekly newsletter. More

Late on june 13th, a curious article appeared in the Wall Street Journal. It said that the Federal Reserve was “likely to consider” raising interest rates by 0.75 percentage points at its meeting on June 15th. The article was unusually silent about its sources. And it proved uncannily prescient. Two days later the Fed did indeed raise interest rates by that amount, its biggest increase in 28 years. Many investors believe the central bank had used the press to warn financial markets about what it would do in advance (albeit not very far in advance). That would make the Journal story an unconventional example of “forward guidance”.Central banks often telegraph what they might do before they do it. This kind of forward guidance is as old as central banking itself, according to Willem Buiter, a former rate-setter at the Bank of England. It is certainly as old as inflation targeting. The Reserve Bank of New Zealand (which was the first to adopt a formal inflation target in 1990) quickly learned that it could move markets with its utterances (what it called “open-mouth operations”). It now publicly forecasts its own decisions. If you want to know where it thinks its policy interest rate will be in the future, you do not have to look out for mysteriously sourced stories in the press. You can just download the central bank’s spreadsheet.This kind of guidance is intended as no more than a prediction, based on the central bank’s fallible forecasts of the economy. It is sometimes called “Delphic” guidance, after the oracle of Delphi in ancient Greece. If the economy defies the forecast, as it usually does, the central bank may well defy its prophecy of its own behaviour. In a paper published in 2012, Jeffrey Campbell, then of the Chicago Fed, and his co-authors distinguished Delphic forward guidance from another kind, “Odyssean”. Odyssean guidance is more than just a prediction. It includes a promise or commitment of some kind. Central bankers use it to tie their own hands, like Odysseus lashing himself to the mast of his ship. Why would they do that? The aim, as the paper put it, is to change public expectations about what central banks will do tomorrow, so as to improve the economy today. In a slump, a central bank might not have room to cut short-term interest rates by enough to revive the economy. (Rates cannot easily be cut below zero.) It might then promise to keep rates low for longer than it otherwise would, even after hearing the siren call of an economic recovery. If its promise is believed, expectations of inflation will rise. That will magically reduce the real cost of borrowing even when the central bank’s policy rate can fall no further. Odyssean language crept into central-bank guidance after the financial crisis of 2007-09. In April 2009, for example, the Bank of Canada promised, with some qualifications, not to raise interest rates for 14 months. In 2016 the Bank of Japan said it would keep easing until inflation had durably overshot its 2% target. Similar commitments were made in the pandemic. When a central bank is stuck close to the zero lower bound, it can at least say what it will do—or refrain from doing—when economic conditions warrant it moving again. Its words speak louder than inaction.But when a central bank is not so constrained, the case for Odyssean forward guidance becomes less clear. If a central bank is free to act, why rely on words rather than deeds? In particular, why bother with forward guidance during a tightening cycle? There is, after all, no upper bound on interest rates. That question was recently posed on Twitter by Jason Furman, a former chairman of the White House’s Council of Economic Advisers. If the central bank knows that interest rates should be higher in the future, there is nothing to stop it raising them now. Indeed, it could increase them up to the point where it is no longer sure if the next move should be up or down. In 2004 Ben Bernanke, a former chairman of the Fed, called this the “bang bang” approach. If a central bank were to adopt it, it would have little need to offer advance guidance about its future actions, because everything it is committed to do, it would have done already. In one go.One reason why central banks nonetheless like to offer guidance is precisely because they dislike the bang-bang approach. They prefer to change interest rates in small increments. Forward guidance allows them to move gradually, while signalling that the first small step will not be the only one. But if investors heed the guidance, the future steps will be priced in to longer-term interest rates straight away. Thus gradual moves in the policy rate can be accompanied by big swings in broader financial conditions.In principle, a central bank could abandon gradualism while still offering non-binding forecasts of what it might do in the future. But such Delphic utterances can be more trouble than they are worth. Financial markets often treat them as promises, not predictions. “People don’t hear the caveats that well,” says Mr Furman. Knowing this, central banks may feel unduly constrained by their past prophecies. That can make it harder than necessary to adjust when their predictions inevitably go awry. The Fed found itself in precisely such a predicament on June 10th, when surprisingly bad consumer-price inflation figures invalidated its recent prediction that it would raise interest rates by no more than half a percentage point at a time.The strong, silent type of monetary policyMarkets react badly when they think a central bank has broken a promise. That may add to volatility in itself. It may also erode the central bank’s credibility, so that when it does need to make a commitment its words are no longer believed. Because promises are hard to keep, a central bank should make no more than necessary.The Fed could not adopt a closed-mouth monetary policy overnight, Mr Furman points out. Preparing markets for such a shift would take time. But the Fed could start considering it for its next tightening cycle. Even better, he jokes, perhaps a pioneer like the Reserve Bank of New Zealand could try it for a year first. ■Read more from Free Exchange, our column on economics:People’s inflation expectations are rising—and will be hard to bring down (Jul 25th)The Fed’s flawed plan to avoid a recession (Jun 16th)A focus on GDP understates the strength of America’s recovery (Jun 9th)For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter. More

Looking back, it is easy to think of stockmarket crashes as abrupt shocks. And some of the most dramatic of them were indeed abrupt. At the onset of the covid-19 pandemic, the s&p 500 index of American stocks plummeted by 34% in a little over a month. The last time Russia defaulted on its debt, in 1998, the index took six weeks to travel from zenith to nadir, nearly taking Long-Term Capital Management and the rest of Wall Street with it. Quickest of all was the lightning bolt of October 19th 1987, or “Black Monday”, which wiped 20% off the market in a single day.The biggest downturns, though, have tended to be much more drawn-out affairs. The bloodbath in equities that accompanied the financial crisis of 2007-09 was no single, vertiginous plunge: it played out over 17 months. Talk of the dotcom bubble “bursting” in the early 2000s can obscure the fact that the journey from peak to trough took two and a half years. The greatest crash of all, beginning in 1929, took nearly three years to run its course.In each case, losing streaks were interspersed by rallies lasting weeks and fitful days when not much of anything happened. If not quite months of boredom punctuated by moments of terror, they were long, uncertain slogs. Today, six months after America’s equity market started falling in the face of persistent inflation and tighter monetary policy, another slog might lie ahead. But when the bottom finally arrives, what will it look like?Like a bubble, capitulation—investors’ jargon for the final, frenzied phase of a rout—is accompanied by a kind of mania. It is the part of the crash when something snaps in the collective consciousness and everyone who is going to give up and sell does. Perhaps they are retail investors who kept their nerve after losing a third of their capital but, seeing another 20% of value vanish, conclude that it really might go to zero and rush to the exit. Perhaps they are professionals who know full well it’s a bad time to sell, but can’t get their risk manager (or their clients) off their back. Either way, it is the violence of the shake-out itself that creates the market bottom: those who refuse to sell at the height of the panic are unlikely to lose their cool further down the line. After the frenzy is over, prices start to climb again.So much for recognising capitulation in hindsight. Spotting it as it happens is harder. Perhaps some clues can be gleaned from how historical crashes have played out. Start with the crudest measures: the length of the crash and the size of the drop from peak to trough. Excluding this year, the s&p 500 has notched up 14 bear markets—falls of more than 20% compared with a recent peak—since the second world war. The average downturn took a little over 11 months and resulted in a decline of more than 32%. Both measures suggest that this year’s losses, which hit 23% in June before rebounding a little, may have some way yet to run. For a more granular picture, consider the rout in March 2020. One lesson from it is that trading volumes spike as the market plummets. Towards the end of the crash, shares in the s&p 500 were changing hands at more than double their average rate in the weeks running up to it. Volumes for stocks in Britain’s ftse 100 tripled. Another signal is that a large proportion of stocks in an index plunge in value. While the downturn in 2020 was at first led by a handful of stocks, by the last phase pretty much everything was flashing red. True capitulation is reached when contagion spreads not just from one stock to another, but across indices and asset classes. Set against those measures, this year’s bear market is yet to reach its culmination. Investors are gloomy, but not so much that they have sold their favourite risky assets. Downward lurches have begun to include defensive stocks, but many of those in sectors including pharmaceuticals and telecoms are still up on the year. And the drops do not yet smack of panic: the s&p 500’s worst day this year was its 39th-worst since the turn of the century. Trading volumes, for the most part, suggest a market that is just about holding its nerve.If capitulation is tricky to pinpoint as it arrives, profiting from it is harder still. How many prices need to be plummeting in lockstep before it becomes time to buy? Trading volumes might have spiked, but have they peaked? Are you sure that you will keep your head when all around you are losing theirs? Studying historical crashes is one thing. Putting their lessons into practice is entirely another.Read more from Buttonwood, our columnist on financial markets:How attractively are shares now priced? (Jul 25th)Is trading on America’s stockmarket fair? (Jun 16th)Tech investors are prizing cash generation again (Jun 9th)For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter. More

In turkey, the abnormal is the new normal. If official figures are to be believed, annual inflation now exceeds 73%. If Turkish consumers are to be believed, it is much higher. Measured against the dollar, the lira resembles a black-diamond ski slope. The currency has lost a fifth of its value against the greenback since the start of the year. The obvious solution would be a dramatic increase in interest rates. But the country’s president, Recep Tayyip Erdogan, refuses to allow the central bank to tighten monetary policy.The shock value of the zany economic theory Turkey’s leader has peddled for some time, namely that the solution to high inflation is low interest rates, has worn off. What has investors and Turkish companies spooked now are the lengths to which Mr Erdogan may go to keep the current monetary settings in place. The spectre of capital controls has begun to loom over the country. On June 23rd the central bank decided to keep its benchmark interest rate unchanged for the sixth month in a row. That much was expected. The surprise came the next day, courtesy of Turkey’s banking authority, known as the bddk. Turkish companies, it ruled, would no longer be eligible for loans in lira if their foreign-currency holdings exceeded 15m lira (roughly $900,000) and if the amount exceeded a tenth of their assets or yearly sales.By forcing companies to sell dollars and euros, the government hopes to breathe some life into the lira. (Turkish exporters already have to convert 40% of their foreign revenues, according to an earlier decision made by regulators.) But the move may also hamstring companies and trigger capital outflows. The more the government penalises foreign-currency holdings, the less able firms are to protect their savings against inflation, undermining confidence. They will also find it harder to buy goods and services from abroad. Some will look for ways to circumvent the new directive, says Durmus Yilmaz, a former governor of the central bank, and will park more money abroad.Turkey’s increasingly unorthodox attempts to support the lira have already taken a heavy toll on the economy and the public finances. Since 2019 the central bank has burned through at least $165bn in foreign reserves by intervening in currency markets. Late last year the government unveiled a scheme to compensate holders of special lira deposits for the currency’s depreciation against the dollar, in an attempt to stop a further lurch. Turks have since poured 963bn lira into the special accounts. Because the currency has nonetheless continued to slide, the treasury owes them billions of dollars. The government’s latest move does not meet the textbook definition of capital controls (measures to stem the flow of foreign capital into and out of the country). But it suggests more severe interventions might be in store if the lira continues to plummet. Analysts say Mr Erdogan would much sooner impose capital controls than allow rate increases. “I’m 100% sure he will not use interest rates as a tool,” says Ozlem Derici Sengul of Spinn, a consultancy in Istanbul. The country is sliding down a slippery slope. ■For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter. More

The federal reserve’s “preferred measure of inflation” is a phrase that often crops up in reporting on the American economy. It stands in for a verbose official name: the personal-consumption-expenditures price index (pcepi). Most discussion of inflation, however, focuses on its better-known and pithier relative, the consumer-price index (cpi).That usually does not matter much. But the gap between cpi and pcepi has recently widened, hitting two percentage points in April, the largest divergence since 1981. So while headlines blare out that cpi inflation is running at more than 8% annually, it is just over 6% in the pcepi world. To be sure, the lower pcepi figure is not cause for celebration. Just like cpi, it is also at a four-decade high. But it is nonetheless instructive to consider why the gap has grown so wide. The simple explanation is weighting. Housing, for instance, is 33% of cpi but just 16% of pcepi. Petrol also has a slightly higher share in cpi. The pcepi gauge is broader, encompassing things purchased on behalf of consumers (such as medical care, even if paid for by the government or an employer). When rents and oil prices soar, cpi inflation tends to outstrip pcepi inflation. The Fed prefers pcepi because it reflects how money is actually spent. If people stop buying expensive cars and spend more on bus tickets, that shift shows up in pcepi; cpi, by contrast, just registers the higher car prices. “cpi doesn’t allow for immediate substitution, which exacerbates the divergence,” says Julie Smith of Lafayette College. In theory that might tempt the Fed to highlight pcepi now. The latest figures were due out on June 30th, as we went to press. Core pcepi (excluding food and energy) is expected to have risen by 0.4% in May, compared with April, slower than the 0.6% jump in cpi. But Jerome Powell, the Fed’s chairman, instead highlighted cpi when explaining the central bank’s jumbo interest-rate rise on June 15th. Partly that is because cpi was published just before its decision. The fact that cpi is more widely discussed, even if less accurate, also recommends it. The central bank’s concern is that inflation expectations are becoming unmoored. If people pay more attention to cpi, the Fed will feel obliged to do so too. For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter. More

Hackers targeted Horizon, a so-called blockchain bridge that lets users swap tokens between different networks.
There are “strong indications” that Lazarus Group, a hacking collective with strong ties to Pyongyang, orchestrated the attack, blockchain analytics firm Elliptic said in a blog post Wednesday.
Harmony said it is “working on various options” to reimburse users as it investigates the theft, but stressed that “additional time is needed.”

A photo illustration showing the North Korean flag and a computer hacker.
Budrul Chukrut | Sopa Images | Lightrocket | Getty Images

North Korean state-sponsored hackers were likely the perpetrators of a hack that led to the theft of around $100 million in cryptocurrency, according to analysis from blockchain researchers.
The hackers targeted Horizon, a so-called blockchain bridge developed by U.S. crypto start-up Horizon. The tool is used by crypto traders to swap tokens between different networks.

There are “strong indications” that Lazarus Group, a hacking collective with strong ties to Pyongyang, orchestrated the attack, blockchain analytics firm Elliptic said in a blog post Wednesday.
Most of the funds were immediately converted to the cryptocurrency ether, Elliptic said. The firm added that hackers have started laundering the stolen assets through Tornado Cash, a so-called “mixing” service that seeks to obscure the trail of funds. So far, around $39 million worth of ether has been sent to Tornado Cash.
Elliptic says it used “demixing” tools to trace the stolen crypto sent through Tornado Cash to several new ether wallets. Chainalysis, another blockchain security firm that’s working with Harmony to investigate the hack, backed up the findings.
According to the companies, the way the attack was carried out and the subsequent laundering of funds bear a number of similarities with previous crypto thefts believed to be perpetrated by Lazarus, including:

Targeting of a “cross-chain” bridge — Lazarus was also accused of hacking another such service called Ronin
Compromising passwords to a “multisig” wallet that requires only a couple signatures to initiate transactions
“Programmatic” transfers of funds in increments every few minutes
The movement of funds stops during Asia-Pacific nighttime hours

Harmony said it is “working on various options” to reimburse users as it investigates the theft, but stressed that “additional time is needed.” The company also offered a $1 million bounty for the return of the stolen crypto and information on the hack.

North Korea has frequently been accused of carrying out cyberattacks and exploiting cryptocurrency to get around Western sanctions. Earlier this year, the U.S. Treasury Department attributed a $600 million heist on Ronin Network, a so-called “sidechain” for popular crypto game Axie Infinity, to Lazarus.
North Korea has denied involvement in state-sponsored cyberattacks in the past, including a 2014 data breach targeting Sony Pictures.

WATCH LIVEWATCH IN THE APP More

Europe’s energy war is becoming total. Having already banned or promised to ban imports of Russian oil, leaders of the g7 group of countries said on June 28th that they would explore ways to cap its price, as well as that of Russian gas. Populations are being prepared for pain. Britain has hinted that it will reform its power market to curb the influence of natural gas on domestic prices. French utilities have called on consumers to cut energy use “immediately”. One goal of such manoeuvres is to deprive Russia of much-needed revenue. Another is to try to ward off the energy crunch that looms over Europe. Only a month ago it looked like a crisis might be avoided—just. As America cranked up its exports of liquefied natural gas (lng), its share of Europe’s total gas imports rose from 6% in September to 15% in May, even as Russia’s slumped from 40% to 24%. What gas Europe needed from its troublesome neighbour still flowed. Russia did turn off the taps to Bulgaria, Finland and Poland after they refused to pay in roubles, as it had demanded, but they bought little in the first place. The continent’s reserves were building up at a record pace.Then two things happened. On June 8th a fire shut down the Freeport gas-liquefaction facility in Texas. The outage, which is expected to last 90 days, has deprived Europe of 2.5% of its gas supply. A week later Gazprom, a Russian energy giant, said that supply to Europe through the Nord Stream 1 pipeline would fall to just 40% of capacity, ostensibly because of the delayed return of a turbine being serviced in Canada (Gazprom blames sanctions). That took another 7.5% off Europe’s supply. There are few other sources. lng terminals are running at full tilt. Little more can flow through pipelines from Algeria, Azerbaijan or Norway. Restarting the Dutch gas field of Groningen, which once supplied as much as Nord Stream but was phased out after causing earthquakes, is politically tricky. The result, reckons Rystad Energy, a consultancy, is that the eu’s gas-storage facilities will be two-thirds full by the end of October, short of the bloc’s target of four-fifths. There is even a fear that Nord Stream, which is due for regular servicing in July, will not restart once the maintenance ends. If so, Europe may enter the winter with storage levels at just 60%. That raises questions about the continent’s ability to stay warm this winter. Moreover, gas-fired power generation has become the marginal source of electricity supply over the past year in western Europe, implying that its cost is what sets power prices across the region. Last year this was partly because renewable-power generation was hampered by droughts (and thus feeble rivers) and insufficiently strong winds. This time the problem is that nuclear reactors in France require maintenance and are running at less than half their capacity. That is draining Europe’s power supply—just as a heatwave in the south is boosting demand for cooling. France’s spot power prices averaged €197 ($206) per megawatt-hour in May, compared with €15 a year ago. One way Europe copes with imbalances is through trade. France, once the region’s largest exporter of power, is now buying electricity from its neighbours. Wholesale gas is now dearer in Germany and eastern Europe, because of the reduction of supply through Nord Stream (see chart). That will incentivise flows from Britain and Spain, which have lng terminals. But it will not increase the aggregate supply of fuel and power. And there are signs that, in a crunch, unity could fray. On June 29th it emerged that one of Britain’s first steps in an emergency would be to cut off gas to mainland Europe. eu countries are thus scrambling to find alternatives to gas. Germany has reversed plans to retire more than one-fifth of its coal-fired power stations this year. Austria, Britain, France and the Netherlands have said they may either delay closures of, or reopen, coal plants. Some of the seven European nuclear plants that are due to be shut by the end of winter may also be kept operating a bit longer. Yet even if all of this is done, gas will probably continue to set electricity prices. A futures contract for Germany’s “baseload” (ie, non-renewable) power in December currently trades at 25% above gas-fired power-generation costs, suggesting that the market is pricing in a gas crunch, plus a premium. A persistent supply shortfall means demand will have to adjust. High prices might do part of the job. But rationing may also have to be imposed on gas- and power-hungry companies, such as producers of fertiliser, glass and steel. How drastic those curbs are, and whether they end up being extended to households, will in turn depend on two wild cards: winter temperatures on the continent; and the extent to which China bounces back from covid-19 lockdowns and soaks up more lng. Europe has so far been unlucky in its energy war with Russia. If it is to keep the lights on until the spring, that needs to change. ■For more expert analysis of the biggest stories in economics, business and markets, sign up to Money Talks, our weekly newsletter. More