November 20th, 2014
in aa syndication
Age of Wisdom, Age of Foolishness (51)
The recent policy maker induced market correction, suggested in Age of Wisdom, Age of Foolishness (45) “Worlds in Motion”[i] and initiated in Age of Wisdom, Age of Foolishness (46) “If At First You Don’t Succeed…..”[ii] was swiftly executed; so that those who missed it were soon calling for a return to the easy money status quo that will lead to an equity market retracement and then additional gains. Policy makers have other ideas in mind however; and there will be no return to the pre-correction fundamental status quo. In fact, policy makers are now intent upon fundamentally changing the behaviour of market participants instead.
“All Bound for Moo-Moo Land.”
Age of Wisdom, Age of Foolishness (26) ”Milking It For All It’s Worth”
In Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” Janet Yellen was observed to be signalling that Helicopter money was the next bullet on the list of policy options. QE can be understood as a temporary provision of liquidity; which has boosted the capital markets without having anywhere near as strong an impact on the real economy. The Helicopter will be focused on the real economy; which it will impact by making the temporary QE permanent and then redistributed to the Middle Class through the reformed tax code. Such a fundamental change in policy, determines that there can be no return to the original status quo that the capital markets professionals are longing for. Dodd Frank and Basel III were enforced upon the capital markets institutions; in order for them to get their houses in order and embrace the Fed’s intentions to boost the real economy. Instead, the capital markets leveraged up the QE in financial assets; which the Fed has responded to by preparing the Helicopter.
“Babble from the Tower of Basel.”
Last week, the BIS signalled that QE had reached the limits of efficacy; and was now creating the dangerous level of risk in financial assets, which will lead to another crisis unless the central banks intervene to control asset prices. This signal can also be seen as a tacit acceptance that QE has run its course; and that the Helicopter’s time has come. BIS Chief Economist Borio, even went to the length of describing the effect of QE; in terms which resonate strongly with what has been referred to as the Corporate Stagflation Strategy in the Age of Wisdom, Age of Foolishness (26) “Milking If for All It’s Worth”[iii].
“It should now be dawning on the Fed that it has created another monster, by inflating equity prices, which will ultimately lead to Stagflation.”
“Managers have preferred to use the money to finance takeovers or share repurchase schemes rather than in their own business. That's a clear signal that something is amiss.”
It looks as though the central banks have started to wake up. The central bank of central banks has therefore just signalled that QE has reached its apotheosis. Therefore, there will not be the same kind of market retracement that is currently expected. Monetary and fiscal policy is moving off in a different direction; which will ultimately take capital markets to new risk asset highs, but getting there will not be a simple retracement of the past.
“They’ll be back.”
Goldman also confirmed the Stagflation strategy; when it reported[vi] that in its opinion the recent equity sell-off was driven by the slowdown in share buybacks pre-earnings reporting season. Goldman also signalled that it expects further economic weakness, to stimulate even greater buybacks; which will push the equity market to new highs. Clearly for Goldman it is business as usual. IBM’s latest earnings shocker[vii]was a classic illustration of how weak global earnings prompt accelerated share buybacks; euphemistically referred to as the company investing in its own growth story. This tautology signals that there is no real growth to invest in; and that the company can’t even afford to return cash to shareholders the traditional way.
“Mind the Gap Janet.”
Perhaps the best illustration of the Stagflation problem comes from the divergence of hourly earnings and rents[viii]. QE has gone into rental dwelling investment, rather than into salaries to pay the rent. Rental investment does not however extend to increasing the rental stock, to levels of supply which will make rents trend lower. Higher rents are stimulating a construction cycle, but this clearly does not have the oversupply bubble characteristics of previous real estate cycles.
The Fed however has different plans to encourage a change in corporate culture; in order to promote capital investment and job creation. This coming culture shock will involve higher interest rates to stimulate said capital investment. The rise in US interest rates will not be punitive however, because inflation is currently under control and foreign investors are dumping their own currencies to pile into the US Dollar. The Fed is intent on creating a rise in inflation and interest rates, which signals a return to the traditional form of economic expansion before the experiment with QE occurred after the Credit Crunch. Getting there unfortunately involves an experiment with Helicopter money however.
"More stitches less riches."
Bill Dudley gave the strongest indication of what this brave new world will look like last week. We have suggested that the Fed is disintermediating the commercial banking system, because it has been “Zombiefied” (the banking system and not the Fed, that is!). Using Basel III and Dodd Frank as an excuse, to get these rules watered down and more QE supplied, the large banks have tightened liquidity and raised its price. They threaten to create another recession, by curbing lending, if the regulators don’t ease back on the rules. Since there is however no demand for more credit, the recession will come about in any case; so the banks’ role in it is marginal at best.
There has however been no drain in liquidity from the Fed; so ostensibly the liquidity is out there. Where it has been hiding, until the recent correction, was in leveraged securitised risk. When the Fed engineers a correction in risk assets however, this liquidity doesn’t get transmitted to the real economy.
In a correction, capital markets liquidity dries up; and the banks dump securities to avoid greater capital calls. The transmission mechanism and money multiplier of fractional reserve banking, on which the Federal Reserve System is built, is frozen in paper assets. The Fed’s attempts to unfreeze it, simply led to perma-freezing.
A new transmission mechanism is required, which detours round the banks; and goes from the Fed’s balance sheet through the Treasury to consumers’ accounts. Where it will be after the Helicopter has landed, is in the checking accounts of the Middle Class. In this new location, it has the potential to ignite a consumer boom; and no small degree of inflation also, which will then be the Fed’s next major task of policy action.
Dudley signalled the Fed’s displeasure[ix], with the Federal Reserve banks who own it, when he made it clear that banks that do not get with the new programme and start lending instead of leveraging will get broken up. Clearly disintermediating involves breaking the large banks down, into entities which can be manipulated with greater ease when the Helicopter lands.
The scope of reform, which is choking off the banking bid for assets, has now moved into the mutual fund sector. Collateralised Loan Obligation (CLO) funds are the latest casualty[x]; which has been forced to pull back its aggressive bid for CLO’s because it is being forced to keep more skin in the game as a capital buffer against losses. Fund managers will be required to hold 5% of the loans they collateralize, or the banks that create them must take on board this residual position. With a smaller resultant bid for CLO’s, the securitization process and also the underlying loan business receive another headwind; and credit becomes further constrained and more costly. It is becoming clear that the Fed understands that it has pushed on a string with QE and instead has created excessive risk in asset prices; so it is choking-off the supply of credit under the guise of macroprudential regulation.
“Spinning Assets into Euros.”
Two weeks ago, the ECB announced its exasperation with the slow turning wheels of EU policy; which would force it to bring forward the start of the Asset Backed Security (ABS) purchase programme. Last week, true to its word, the ECB began the programme with the very strong signal of buying French ABS[xi]. This signal implies that the ECB has already perused the new French budget plans and wishes to endorse them. In reality, it means that the ECB has seen all the Eurozone nation budget plans; and has concluded that in aggregate they will not move the growth needle, ergo the ABS purchases need to begin early. The problem for the ECB however, came from the market reaction.
The bond markets rallied as speculators front ran the ECB; however this was not transmitted with the same ferocity to the equity markets. On the second day of ABS buying, the ECB targeted Italian bonds and got more of a bang for its buck, because the volatility of Italian assets is greater. It therefore seemed that the ABS buying was successful; however in truth the impact is technical and related to asset volatility rather than faith in the ECB. It would appear that the Eurozone still needs full blown QE to solve its problems therefore. The euphoria over the covered bond purchases was short lived; when Luc Coene signalled that there was as yet no programme in place to purchase corporate bonds as part of the ABS programme[xii]. The ABS purchase programme is beginning to look more like another bailout of the banks, rather than a serious attempt at monetary stimulus.
Its coincidence with the ongoing ECB banking analysis, results of which will be published on October 26th, is a cause for suspicion. This suspicion should be heightened by the fact that the ECB is coincidentally providing a four year term of cheap bank financing, at even cheaper financing rates than the programme that is expiring[xiii]. The banks are therefore availing themselves of every opportunity to hang in there, rather than to expand lending. European banks would appear to be as “Zombiefied” as their American counterparts.
These “Zombified” EU banks have however found a “Federal Champion”; who will help the EU achieve a compromise, which will let the banks off the hook in terms of further tightening in capital adequacy and lending standards rules. Christian Clausen, the President of the European Banking Federation, signalled that the limit of regulatory restriction has now been reached[xiv]. Allegedly, the rules are incoherent and impractical; which has had extremely negative implications for the creation of Eurozone credit. It was no coincidence that he was speaking, just as the banks are undergoing their appraisal by the ECB. Clearly Clausen hopes to convince the ECB that the banks are willing and able to advance more credit, if only Draghi would help them water down the capital and liquidity rules which constrain them.
“The boy with the thorn in his side.”
Jens Weidmann continues to inflame the situation; and by so doing increases the demands for ECB QE. In his latest interview, he opined that even Germany’s weak economy does not need a fiscal stimulus[xv].
“No S**t Sherlock!”
What the BIS warned of and what Draghi knows, is that there has been a horrible mismatch of fundamental issues and policy solutions. As with the US, UK and Japan, Europe has an aggregate demand problem not a credit supply problem. QE and ABS buying however, are credit supply solutions i.e. pushing on a string that the consumer is not pulling. The ample credit is in financial assets, rather than the real economy; so supplying more credit just makes the whole thing more unstable, as the BIS recently warned. The net result is that speculators get carried away, pricing the non-existent consumer pull into asset prices. Asset prices themselves, then become a secondary problem to the original lack of demand problem. When the two become too far out of line, asset bubbles are created; the bursting of which creates further economic problems. The BIS has called time out on the credit supply side solutions. The Fed is moving towards aggregate demand management with the Helicopter. Europe and Japan are still pushing on a string, because they lack the fiscal room to boost aggregate demand. The UK is trying to boost aggregate demand, even though it can’t afford it. Germany’s solution for Europe, is to deflate it to levels which are supposed to make it competitive enough to somehow stimulate aggregate demand from the global economy.
Germany’s solution relies upon the archaic and arcane Say’s Law; which the Austrian School could never fully prove in practice and which Keynes disabused. Unfortunately, the rest of the global economy is deflating and competing with this German solution. Keynes would be turning in his grave, at the simplicity of the problem; and the fact that all his teaching and actions have been obscured by the mountain of debt which prevents the current fiscal stimulus. Keynes himself suggested inflating out of this kind of debt and stimulating aggregate demand with fiscal expansion as the solution; and one suspects the MIT crowd in global policy making will eventually get there in the end.
Markets therefore squeezed higher last week, as traders front-ran the ECB’s well telegraphed covered bond buying. The devil is however in the details. Firstly, aggregate demand has not been stimulated; so a bubble is again inflating in risk assets. If the ECB bought good assets, with healthy cash flows, it has succeeded in taking good assets out of the banking system; thereby making the banking system weaker. If the ECB has bought “dodgy” assets, as the Bundesbank fears, then the banks are left with good assets; which they are more likely to cling onto, rather than to replace with new lending into a weakening Eurozone economy. In this case, the problems are hidden on the ECB’s balance sheet; and a huge bust up with Germany will now ensue.
“Hiding in Plain Sight.”
Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” suggested that:
“At some point a challenge to Hollande is to be expected, once the would be challenger has revealed him/herself; at which point the President will move from Purgatory to whichever destination awaits him.”
This inevitable challenge materialised last week[xvi], when Prime Minister Valls emerged as the main challenger to Hollande. The latest PMI data[xvii] showed that France accelerated into recession, as the rest of the Eurozone started to recover last month. Time has run out for Hollande, on both the domestic and the international front.
“Italy Changes Sides…..Again.”
“A Broken Axis.”
Age of Wisdom, Age of Foolishness (41) “Axes of Evil”[xviii]
As the strikes begin[xix], Matteo Renzi is not waiting around to get politically assassinated. Having broken with his Axis partner Germany; he is now threatening[xx] the EU with disclosure, of how the invisible hand of Germany pulls the strings at confidential negotiations on debt issues. Should this murky world of undemocratic politics be exposed, the democratic process in EU nations will reassert itself swiftly; which would put Eurocrats out of very lucrative jobs. Rather than let this happen, they will find a way to accommodate Renzi, with some form of fiscal expansion.
“Not Strength Through Joy.”
The truth may soon be out, that Germany’s supply side miracle is actually based on sub-contracted labour[xxi]; which is cheaper in terms of compensation and benefits, than that of its unionised counterparts within Germany and across the Eurozone. Whilst the Keynesians lecture that aggregate demand needs stimulating through higher wages, the Germans are busily chipping away at this socialist European fabric. This sub-contracted labour issue, is something which appears to vitiate against the very core ideal of Europe; which is supposed to provide fairness to employees and avoid their exploitation. One senses that an embarrassing behind doors discussion, on this very un-European practice by Germany, is about to occur; if indeed it has not done so already.
“Give ‘em enough rope Jose!”
Outgoing EC President Barroso began the process of creating the “Brexit” risk premium in UK risk assets last week; when he opined that Britain will lose the trading privileges which come with EU membership, should it decide to leave in a referendum[xxii].
“The Prestige is Wearing a Bit Thin.”
Age of Wisdom, Age of Foolishness (48) – “Alpha and Omega”
Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” observed the unravelling of Chancellor Osborne’s “Prestige” strategy to rebuild the public finances; and hence his own political prestige. Last week the public consensus turned unequivocally negative. The economic recovery has now been written off[xxiii]. The recovery, such as it was, did not create the higher level of incomes required to create the tax revenues to balance the national deficit[xxiv].
Needless to say, the Public Sector Borrowing Requirement (PSBR) widened in the first half of 2014[xxv]. This deficit widening has occurred, even before David Cameron gave it a further nudge by pledging to cut tax rates, to win some much needed votes before the General Election. Britain started off in the deficit hole; and it is now digging itself even deeper.
If Britain was in the Eurozone, it would now face ejection on deficit rule breaching; so it may as well leave the EU and let the Pound take the strain in any case. It is interesting to posit that such a low wage recovery, is currently what Germany prescribes for the rest of the Eurozone; to balance their national budget deficits. Clearly it hasn’t worked for Britain, so why should it work in the Eurozone? One senses that a dose of Helicopter money is also on its way to Britain. In the Eurozone, it will be shot down by the Bundesbank.
“Northern Soul Boys.”
The “Wolf of Downing Street”, has evidently become the “Wolf of Coronation Street”. George Osborne was observed marching out to election, in Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight”, with an empty fiscal pouch of ammunition; because his “Prestige” strategy has been overwhelmed by underwhelming tax revenues, from an underwhelming economic recovery. UKIP continues to march on Westminster; more alarmingly so for “New Labour” in the North, which was once its traditional home of support.
“Blackadder Goes North.”
Osborne’s cunning plan, is to embrace the economic stimulus of what he calls a “Northern Powerhouse” of large regional cities in northern England. One suspects that this plan will get executed by Private Equity and structured by investment bankers. Goldman Sachs has never been shy about embracing (and often front-running) political bandwagons. Jim O’Neill, the former Chairman and performing pet-Mancunian of its asset management division, learned this technique when he coined the acronym “BRICS”; which was code for Goldman’s big trade to front-run the Trilateral Commission and embrace the emerging markets. Goldman were then able to front-run what was affectionately termed “New Labour”, when its former chief economist Gavyn Davies had the ears of Brown and Blair.
“All Your Dreams Are Made…..”
Since retiring, O’Neill’s strategic positioning has become somewhat more parochial. He was rumoured to be in the running for the Governorship of the Bank of England, before he became a provincial governor. His latest Northern acronym, to go with his latest position, front-runs Osborne’s cunning strategy to create “Blue Labour” for the Tories, through his cunning “Northern Powerhouse” plan.
“The Rovers Return.”
Just as the “Disraelian” Boris Johnson seeks to elevate his political status to Number 10, Osborne has come up with a strategy to save the party; and guarantee its majority in perpetuity by finally getting the Northerners into the Tory broad church aka “Blue Labour”. If Osborne is successful, he will join the panoply of Tory Gods alongside Mrs Thatcher; which is something that Johnson aspires to and Cameron can now only dream about.
“Maybe it’s Not So Grim Up North.”
To O’Neill and Osborne, the “desolate” North is what is known as a “Frontier Market” in the global-macro vernacular.
What they envision, is the World Bank’s strategy for China (see later); whereby a handful of large cities with scale, grow at above trend rates to create the alleged powerhouse. What they have neglected, is that said cities are black holes for the surrounding suburbs; which then lose their talent and wealth to the big hubs[xxvi]. A cursory look at Premier League football, of which O’Neill is a fan, would evince the process in graphic detail.
“Need A Little Time To Wake Up, Wake Up.”
A cursory look at London’s Docklands and the surrounding “frontier” zone, will evince what happens as the result. The new strategy is laughably called “Unleashing Metro Growth”[xxvii]. It could equally be called “Unleashing Non-Metro Decline”.
China’s growth strategy took a massive fundamental blow from the World Bank last week. The current model of urbanization, by migration from rural communities to smaller urban centres, is allegedly sub-optimal; because it does not create the kind of scale effects which China needs to maintain sustainable growth[xxviii]. This sub-optimal strategy therefore shaves large chunks off Chinese GDP; which the country can ill afford going forward. In Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight”, Secretary Lew’s frustration with China’s failure to stimulate domestic demand was observed to be boiling over into a deliberate weak US Dollar policy. The World Bank is clearly in sync with Lew. Further Anglo-Saxon pressure was put on China last week; when the Conference Board suggested that China would start having 4% and sub-4% economic growth by 2020, if the current policy is extrapolated[xxix]. China faces a clear dilemma. If it increases the current economic stimulus, it risks creating another asset price bubble. Currently those in the urban workforce have got stable/falling inflation and increasing wages[xxx]. Those in the rural population are however facing extreme hardship, because the falling inflation impacts the agricultural goods they sell. The World Bank seems to believe that moving the rural population to smaller cities, just perpetuates the deflationary spiral. Clearly China is being encouraged to deploy its own form of Helicopter to stimulate consumption; but in a way that boosts imports and global trade. This boost must also be achieved through the scale of the megacities. The latest Q3 7.3 ish% GDP print[xxxi], just heightens the dilemma. There will be the parochial Chinese policy makers who say that growth is stabilising, therefore no more stimulus is needed. They are however being called out by the global policy makers; who say that China risks low digit growth, which will harm the global economy. Secretary Lew has just threatened China that if it does not respond with alacrity, by stimulating domestic demand, that he will enter into a currency devaluation war.
“Yet Another Stan is Born.”
Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” observed the deepening distrust of Turkey’s regional intentions and capabilities. Last week, Turkey signalled what these may be; when it gave the strongest hint that it would be supporting “Turcoman regional boots on the ground”[xxxii]. This new player was hidden, under the cover of Turkey finally allowing Kurdish fighters to lift the siege of Kobani[xxxiii]. These liberating Kurdish fighters are however from Iraq and not from within Turkey; therefore it can be seen that Turkey is still dividing the Kurds. A new ethnic group has now been inserted into the conflict zone; which will heighten the underlying divisions in a manner which fragments the solution. The Turcomans will therefore contest the territory with both IS, the Kurds and the Iranians. What is most interesting about this new ethnic group, is that their brothers and sisters are also to be found, at the other end of the Silk Road in China. “Turkestan” now emerges to meet the emerging Kurdistan. “Turkestan” is also the spiritual home claimed by the Uighur people; who are currently in conflict with the Chinese government. Turkish Ottoman intentions and capabilities are therefore both regional and global.
“A Stan Has Already Been Born.”
Last week, President Erdogan made his strongest criticism of American support for the Kurds[xxxiv]. Clearly he sees the potential, for US weapons airlifted to the Kurds, to be used against Turkey. His fears began to crystallize as two rival Kurdish factions in Syria joined together[xxxv], under the financial and military umbrella of the Kurdish regional leader in Iraq. Almost immediately, the vendetta between Turkish Islamists and Turkish Kurds started to produce fatalities on the Turkish side[xxxvi]. A Kurdish state which spans the borders of Syria, Iraq, Iran and Turkey is now coalescing, into something that could easily try and become a more permanent topographical feature on a regional map. Perhaps in response to this Kurdish development, Iran asserted its control over the Interior Ministry of Iraq[xxxvii]; when its favoured contender Mohammed Salem Al Ghabban became the only candidate for the Interior Minister vacancy. Iran now controls both the office of the Prime Minister and the Interior Minister.
“The Madame Butterflies that Stamped.”
Consensus started to build that Japan is now irreparably damaged. The government revised down its growth projections for the second consecutive month[xxxviii]. A third month of lower revisions, will provide enough chart points to begin a trend. There has been a hint of domestic resistance to the weak Yen policy, from both business and finance in recent weeks. This suggests that Abe is facing a challenge. The resignation of two female cabinet ministers[xxxix] for improprieties last week, clearly shows that this hidden revolt is breaking out. The resignation not only evinces an old chauvinist reaction; but also links this group to the old guard who believe in sound money and the strong Yen.
“Never a lender nor a borrower be they.”
What was less broadly advertised, is the fact that the BOJ is now missing its QQE JGB buying targets[xl]. This miss is occurring, because banks are struggling to create lending assets; and are therefore forced to buy JGB’s. Even with their current overweight positions in JGB’s, the largest banks still need to raise about $100 billion in capital under the new Basel III rules[xli]. The non-JGB assets on their books must therefore be extremely risky. When the big Yen sell-off was viewed as attractive, the banks readily bought US Treasuries as assets; therefore creating a self-fulfilling prophecy of a weaker Yen. It is now evident that the domestic economy has no use for credit of any kind. Rather than buy more Treasuries, to weaken the Yen further however, the banks are now back to hoarding JGB’s again. The response, by the BOJ, has been to make interest rates negative at the short end of the yield curve[xlii]; so that one can buy Japanese Bills from the Treasury and then sell them to the BOJ for a profit. In this way, the BOJ artificially meets its buying targets and the Treasury can fund its ballooning deficit. The negative interest rate scenario, however opens the trap-door beneath the Yen; which is now back in free-fall mode. Negative short-term interest rates make longer dated JGB’s attractive from a carry and relative value basis; so hopefully the bid for longer dated JGB’s will prevent the Yen from falling out of bed completely. One can buy longer dated JGB’s and then roll them down the yield curve and flip them to the BOJ, for an even bigger profit, when they become short dated. The Japanese banks will no doubt be doing this all day; since the capital required in this exercise is minimal and the return is guaranteed. It won’t do anything for the real economy, but it will be a sweet ride for the financial economy. The BOJ has decided to challenge the orthodox view of the BIS (see above); which will have negative implications for the Yen. The Yen Carry trade is back on with a vengeance; which has positive implications for all global risk assets.
“Lines of Conflict”
Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” concluded that the battle lines, over world’s available Carbon Budget, were being drawn between the developed and developing nations. America, despite President Obama’s best efforts, has once again returned to its great polluting ways[xliii]; which puts it on a direct conflict line with India and China. The American skirmishing with China, is now breaking out into all-out-warfare; as America put pressure on its trade partners not to sign up for the inauguration of China’s alternative to the Asian Development Bank aka the Asian Infrastructure Investment Bank[xliv] (AIIB). The twenty attendees are virtually client states of China in terms of aid received from and trade with the new superpower.
“The Sturm und Drang Driving EU Emissions Policy.”
The EU has taken the moral and environmental high ground. The EU will easily meet its 2020 Carbon reduction targets; and has just agreed to even tighter limits by 2030[xlv]. Whilst there is no doubt that the principled EU stance has much to do with environmental concern, one can also see the invisible hand of Germany inside the EU sock puppet.
“The New Wirtschaftswunder.”
Age of Wisdom, Age of Foolishness (50) “Hiding in Plain Sight” concluded that Germany was embracing the Energiewende as a matter of energy security; and also to restructure its economy to become more competitive. The EU’s pursuit of tighter emission controls legislation bears all the hallmarks of the German Energiewende.