Taper Tantrum Redux
Age of Wisdom, Age of Foolishness (54)
“No More Tantrums.”
“They’re creepy and they’re cookey.
The Statements are quite spooky.
Their policy is flukey.
Yel – lens F-O-M-C.”
(Age of Wisdom, Age of Foolishness (52) “Deathly Hallows”)
Following on, from the October FOMC meeting, the Fed smoothly eased into tightening mode. Janet Yellen formally confirmed that tightening mode has been entered, at the Bank of France conference in Paris a few weeks later; and also warned that this period would involve considerable volatility.
Having already failed once to execute this move, during what has become fondly known as the “Taper Tantrum”, the Fed is assiduously trying not to repeat the exercise. The last time around, the Fed ended up having to do some unwanted extra easing, which pushed asset prices to dangerous valuations versus the meagre level of economic activity which ensued.
In order to pull it off this time, without triggering recession and/or another round of unwanted QE, the Fed is working on its guidance. It fell to Loretta Mester to be the first Fed official to take ownership of this delicate issue, after the end of QE was signalled at the last FOMC meeting. Last week, she set out a roadmap[i] for how the Fed can change its style and process of guidance, in order not to repeat previous mistakes in perception by the markets.
In her vision, there are three "suitable amendments" to the widely cited “anonymous” charts, that the Fed publishes on a quarterly basis, known as the “summary of economic predictions” (SEP’s), showing the expectations of its individual policymakers.
Mester opined firstly, that the Fed should clarify, without naming names, that an individual policymaker made a specific array of predictions. It should also adjust the SEPs to show the degree of uncertainty officials attach to their predictions. Thirdly, the Fed should highlight the "consensus view" - or the stance of Fed Chair Janet Yellen and other core policymakers - separately from the outlying views.
Mester’s solution is both predictive and prescriptive; whilst at the same time introducing the notion and Yellen’s definition of the “consensus view”. This definition supports the conclusion, expressed in Age of Wisdom, Age of Foolishness (53) “Lame Ducks”; that Yellen accommodated the Hawks in order to end QE and comply with the strong US Dollar policy currently taking priority in American policy making. Since these Hawks will soon be retiring however, the “consensus view” will still be strongly influenced by Yellen, Stanley Fischer and Bill Dudley (aka Mester’s “core”) going forward.
The outlying views, which should be taken as those of Kocherlakota for the Doves and Plosser and George for the Hawks, have been neatly eradicated as statistically insignificant on the forward guidance distribution curve; so that they cannot create the kind of confusion and volatility that led to the problems associated with the previous “Taper Tantrum”. Yellen’s voice has therefore been amplified by Mester’s proposals on guidance. This leaves the likes of the “volatile” James Bullard even further out in the cold. Just to anchor perceptions, on the correct current “consensus view” baseline, Mester also opined that she sees rate increases beginning in mid-2015[ii].
Bill Dudley then threw his weight behind the “consensus view” and Mester’s roadmap for communication strategy, when he concurred with the 2015 tightening baseline scenario[iii]. Dudley adopted the new guidance convention; by commenting that the capital markets discounting, of this tightening start point, was in his opinion correct. Clearly going forward, Fedspeak is going to be a commentary about what the market is discounting; rather than what the economic data is saying.
The Fed is therefore now in the realms of forward guidance rather than living in the past by reacting to historic data. The risk is however that the Fed (and the market discounting mechanism) loses track of what the historic data is saying; as both counterparts play at semantics. The Fed as an institution must have completed its training in Behavioural Finance Theory; and now feels ready to apply it with great enthusiasm.
Dudley also did his bit for the strong US Dollar strategy[iv]; by opining that he saw a few bumps ahead in the markets as they adjusted to the Fed exit. He was very careful to say that the markets were correct to punish the Emerging Markets and high beta asset classes, last time during the “Taper Tantrum”, rather than the core American assets. Dudley therefore confirmed that the Fed wishes the US economy to emerge unscathed from the exit of QE, whilst the rest of the world goes up in volatile smoke.
“Hands-Off the US Dollar!”
Age of Wisdom, Age of Foolishness (37) “The Third Mandate”
China signalled why America suddenly went into strong US Dollar tightening mode last week. For historical context, it is useful to reprise what was written in Age of Wisdom, Age of Foolishness (37) “The Third Mandate”[v].
“The BRICS signalled that they anticipate another economic crisis soon; and intend to try and get ahead of it. They used the Fortaleza summit to announce their intentions and capabilities, in the form of rival institutions to the World Bank and IMF; which will be based in China and have a rotating presidency[vi]. America and the EU immediately responded by tightening sanctions on Russia[vii]. Economic warfare is therefore underway, which runs parallel to the unfolding military conflicts; as the US Dollar hegemony is once again challenged by the multipolar world order.”
China used Obama’s defeat in the Midterms as the springboard to launch its counter attack on the “Pivot”. This counter attack will come in the form of the rebuilding of the Silk Road from China to the Mediterranean; which is a territory with at least three quarters of the world’s inhabitants and most of its known natural resources. Xi Jinping chose the APEC Summit to officially launch the Silk Road project[viii].
The global centre of political and economic gravity will therefore shift dramatically from the Mid Atlantic to Iran. This strategic vision first had its epiphany back in the days of Jimmy Carter, when it was known as “Brzezinski Doctrine”; it was then “changed” to become the “Pivot” when Brzezinski became Obama’s advisor in 2007[ix]. American strategic interest in Iran can therefore be fully understood, in light of its location halfway along the Silk Road.
“Own-Goal Scoring Opportunity .”
“New (World) Order – World in Motion.”
Age of Wisdom, Age of Foolishness (45) “Worlds in Motion”
Age of Wisdom, Age of Foolishness (53) “Lame Ducks” observed the strategic weakening of the Obama administration, after the “shellacking” of the latest Midterm elections. Iran had been capitalising on the foreign policy by decree, employed by the President thus far. The Midterms however forced the President to seek Congressional authority for future strategic foreign policy initiatives.
It was observed that nuclear negotiations with Iran would be significantly impacted upon by the new political status quo in Washington. Against this reality, “Chickenshit Gate” and the deterioration of relations with Israel have also reached an interesting point. Given Obama’s political weakness, it was therefore no surprise to read in the Journal[x] that he has allegedly reached out to Iran in secret; and traded nuclear concessions for support in dealing with ISIS. Ayatollah Khamenei’s vision of a “New World Order”[xi], in which Iran has a bright future, alludes to this secret diplomatic initiative.
Should the Congress investigate this clandestine diplomacy in detail, the President will find himself even more isolated. It would therefore be no surprise to see National Security Adviser Rice take the fall for the President once again, which seems to be her job description, for the secret diplomacy with Iran. Emboldened by its strategic importance, Iran then leveraged the deteriorating relations between Russia and the West into the purchase of six new Russian nuclear reactors[xii], just as the negotiations began to falter.
“The Curse of King Tut Air-Strikes Again.”
To try and balance the emerging Iranian influence, stalled diplomatic relations with Egypt were revitalised in order to promote it as a regional Sunni proxy once again; under the disguise of America’s largest ever trade delegation’s visit to the country, led by Ambassador David Thorne last week[xiii]. It was then followed up by the IMF[xiv] mid-week. The Egyptians are in dire need of support; as according to Citibank the fall in the oil price has reduced the financial support from the GCC[xv].
“Discretion is the Better Part of His Valour.”
Sensing that he is on shaky ground at home, as well as with America after “Chickenshit Gate”, Prime Minister Netanyahu dialled down the rhetoric on Israeli unilateral military action against Iran[xvi], in favour of sanctions. Israel has understood, to its disgust, that America currently prioritizes the strategic importance of the “Pivot” and China’s Silk Road above the Arab-Israeli peace process.
“In Xanadu did Kubla Khan
A stately pleasure-dome decree.”
China intends to be the global exporter of capital, over the next decade, which will finance the capital investment needed for the global centre of gravity shift to the east. Currently China can only recycle its hard currency reserves, so it is not really a source of capital.
In order to become a true economic superpower, China must liberalise its capital markets and allow its currency to freely float. China must also be prepared to run trade deficits with its trade partners, as America does, in order to tie them in to its global hegemonic currency ambition.
America is however not waiting around idly for the US Dollar to lose its reserve status. America has reduced its budget deficit, at the expense of its domestic economy; in order to meet the Chinese threat with a strong US Dollar and reduced dependence on foreign financiers of its debts. Capital, in the form of hard currencies will therefore leave China, well before its own currency is freely floating. China will then need its foreign currency reserves, to protect the value of the Yuan, so it will be unable to be the exporter of capital and hence the centre of global economic activity that it hopes to be.
Janet Yellen was therefore forced to end her enthusiasm for the Helicopter prematurely, because America’s national security interest demands a stronger US Dollar and hence tighter monetary policy. Ironically, all Obama’s architects of the “Pivot” are no longer employed in its execution[xvii]; so some new hires are needed. Perhaps Mr Brzezinski himself will make a comeback, as he is the only one truly qualified to execute the plan.
“He’s Naughty by Nature”
A “shellacked” President Obama was forced to be circumspect at the APEC Summit; in a mission to try and salvage some tangible diplomatic victories to take back to the hostile Congress. He also needed to assure nervous Asian trade partners that he could still protect them from Chinese aggression[xviii]; so that they would be encouraged to take America’s Trans Pacific Partnership (TPP) over the APEC Free Trade Zone being promoted by Xi Jinping. China opened the proceedings in an inflammatory fashion, displaying its new stealth fighter[xix].
“Relative Strength Index.”
This immature posturing, far from humbling President Obama, probably got Congress and the rest of Asia on his side. He was also able to score some points by successfully agreeing an emissions control agreement[xx] and an IT tariff agreement[xxi] with China. The emissions agreement is however a win for China, strictly speaking; because America agreed to cut emissions but China only agreed to increase the share of renewables in its expanding energy output. China therefore didn’t cut emissions at all; it simply allowed for higher emissions, by covering them with an additional stimulus to its own renewables industry.
After China had done its flexing in public, it then signalled to much less fanfare that it would be revising down its future official economic growth target; presumably because it has no hope of hitting it[xxii]. It was also reported that a great deal of its previous growth over-achievement, was funded by its National Pension Fund placing money on deposit with the banks, for a minimal rate of return, which the banks then lent out for bubble rates of return which can no longer be repaid by the borrowers doing the alleged over-achieving.
China’s pension system is therefore bankrupt[xxiii]; in addition to the liquidity and capital hole in its banking system. The conundrum associated with low deposit rates is even more troubling. The policy makers have promised to liberalize deposit rates by mid-2016[xxiv], so that they can more accurately reward depositors for risk. Deposit rates are therefore set to rise; which will be an economic headwind.
If deposit rates do not rise however, capital will leave China and create an even bigger economic headwind. The policy makers must therefore choose their poison; but either choice will taste bitter and slow economic growth. One suspects that the option to liberalize deposit rates will be enforced by capital flight into the US Dollar in any case. The Emperor of the Silk Road therefore has no silk pajamas!
“It’s Going to Get Bumpy.”
Mark Carney will once again be presiding over the chaos in global capital flows, as the Fed lumbers towards the well signposted exit. Carney was given another three years’ tenure in charge of the BIS Financial Stability Board (FSB)[xxv]. As he took up his reappointment, he warned that the global economy could get “bumpy” again[xxvi]. His own contribution to the bumpiness came last week, when the FSB signalled that systemically important banks will have to hold twenty five percent capital loss buffers by 2019[xxvii]. The FSB has just systemically tightened global monetary policy without the direct agency of central banks.
It should also be remembered that Carney replaced Mario Draghi in this position, when he moved to become President of the ECB. Clearly last time around, the “Taper Tantrum” was exacerbated by the ECB’s inability to replace the liquidity that the Fed was considering draining. The Fed was then forced to ease on the behalf of the ECB. Going forward it is therefore moot, whether despite his strong words and the market anticipation of strong ECB action, that Draghi will actually deliver.
“Germany Goes Into the Next Crisis, With a Budget Surplus, For the Above Reason.”
Draghi may not be able to deliver, because Germany effectively undermines his ability to do so. Age of Wisdom, Age of Foolishness (53) “Lame Ducks”, explained how Germany was going after Draghi’s autocratic and secretive modus operandi. His perverse behaviour was enforced by previous German attempts to scuttle his policies before he could announce them.
A hint of the impending dialectic struggle was given by Jens Weidmann’s vocal reaction to Draghi’s press conference last week. Clearly Weidmann had no foreknowledge of Draghi’s extemporising. Weidmann therefore reacted to Draghi by opining that the ECB’s planned balance sheet expansion is an “expectation and not a target”, as far as he is concerned[xxviii]. The positive sentiment projected by Draghi, at his press conference, was therefore totally deflated by Weidmann.
Speculators, chose however to ignore Weidmann’s warning; and focus on the reality that Germany is in a technical recession. It is assumed that Weidmann is either bluffing, or that Germany will panic and allow Draghi to deliver what he has promised. These are very brave assumptions to make, given the strength of Weidmann’s invective and the clear breakdown in relations between Draghi and himself.
The speculators have also ignored the fact that Germany is running budget surpluses deliberately; in order to be prepared for the next “bump”, of which Dudley and Carney have forewarned, as capital flies from the Eurozone. Germany therefore, fully expects to get through the next crisis and recession, without the burden of debt and the need to rely on foreign lenders or foreign central banks to buy its bonds. This position would seem to diametrically oppose Mario Draghi, who is promising to buy every Eurozone bond in sight.
Something has to give; and those who assume that it will be Germany, ignore the historical fact that Germany never avoids a confrontation. Germany is also most emboldened when it has been preparing for the confrontation; which in this case it has done by creating its budget surplus. It should also be noted that America has just signalled the conditions to trigger the capital flight that will expose the countries with budget deficits and surpluses. Clearly Germany is taking America at its word; and is prepared to deal with the threat in its own way, rather than by printing money the American way.
“Forewarned and Forearmed.”
It is interesting to observe that just as America is preparing for conflict with China on the Silk Road, armed with a strong currency and financeable Federal debts, Germany is preparing for a world in which strong currencies and no debts are required for survival and global domination. Presumably Germany emerges out of the upcoming conflict, ahead of both the current number one superpower and its challenger. It is therefore no surprise that America has recently been caught spying on Germany with great enthusiasm.
“The Gift That Keeps On Giving.”
Germany has recently been put under the spotlight by the Brookings think-tank[xxix], to try to blackmail it into adopting America’s desired Keynesian solution to the Eurozone crisis, which opined that the Germans still owe America and the allies for allowing re-unification in 1989. Germany stands accused of acting selfishly once again; and pursuing its narrow national interest at the expense of the international community and the global economy. This narrow national interest used to be known as “manifest destiny” in the German vernacular.
No doubt at some stage, in the near future, Germany will also be asked to pay reparations to the Marshall Fund! The emerging consensus on Europe, is that Germany has so effectively undermined Draghi’s Asset Backed Security (ABS) purchase programme, that its impact has already been rendered ineffective. Draghi bravely hinted that he is open to new unconventional policy tools to boost inflation[xxx], which presumably will involve corporate bond purchases and other “BOJ-like” initiatives.
The German response can be expected to be swift and damning. Now only an expansion of European fiscal policy, led by Germany, will suffice in place of QE[xxxi] by the ECB. The demand for this German fiscal expansion was formally signalled by Jacob Lew; who took the inflammatory step of openly advising on German fiscal policy last week[xxxii]. Germany is however still creating a budget surplus at this point in time; and no doubt Mr Schaeuble will remind Secretary Lew that he is not the German finance minister.
Germany is becoming skilled at passive aggression, rather than the kind historic belligerent reaction which it is currently on trial for allegedly repeating. Der Spiegel did a skilful assassination of Jean – Claude Juncker last week[xxxiii], in which he stands accused of presiding over Luxembourg’s narrow pecuniary self-interest; that motivated the country to create the kind of tax regime which has allowed global tax evasion on a scale that has undermined national treasuries.
Since America has been on the receiving end of some of this tax evasion, Germany can claim that it is acting in the international interest by bringing Luxembourg and Juncker to book. Germany therefore passive-aggressively beats the Eurozone with a big global stick, rather than a Prussian Field Marshall’s baton. Juncker has effectively been discredited and his authority totally undermined, just as the Eurozone goes back into crisis mode.
Age of Wisdom, Age of Foolishness (53) “Lame Ducks”
Germany has already attacked Draghi’s secretive and autocratic leadership style[xxxiv]; so it is clear that the Germans want to enforce a root and branch review of Europe’s political and financial institutions. Clearly, Germany does not think that these institutions and their degenerate leaders pass muster. A crisis of leadership at this time will be the final straw that breaks the Camel’s back. Weidmann took another stab at Draghi and the Asset Backed Security (ABS) purchase plan last week[xxxv]; which underlined the fact that relations between them are at a new low.
No sooner had Weidmann twisted the dagger, than Finland’s ECB Governing Council member, Erikki Liikanen swiftly opined that there was no feud between the two men; and that dialogue between them was actually “rather civilised”[xxxvi]. Liikanen’s swift denial only worked in giving greater credibility to perceptions of the feud.
Russia, sensing that Europe is weak, is now probing the fault lines with greater resolve; in order to find out just how weak it is. Russia is also probing to see where these Eurozone fault lines manifest as NATO fault lines. Russian probing missions[xxxviii] are now at a post-Cold war high and military incursions into Ukraine[xxxix] have started up again. In the past, Russian aggression has only served to unite Europe and NATO. In fact, it was observed in Age of Wisdom, Age of Foolishness (43) “The Wild Geese (Chase)”[xl] that Germany actually became more European during the original Crimean and Ukrainian crisis. This time around however, European solidarity remains to be seen.
“Start spreading the news.
I’m leaving today.”
Mark Carney’s adopted home of Britain provides a classic illustration of the dangers from capital flight into America, in the form of ETF flows[xli], from a deficit plagued country. Britain has been revising higher its budget deficits, because the economic recovery has not been strong enough to create the tax revenues associated with rising salaries. Capital has therefore been leaving for the safety of the US Dollar.
The falling Pound is assumed to be the source of the next economic recovery by UK equity bulls, rather than a symptom of the fact that the recovery is over. When capital leaves a nation that is already in debt, it is hard to sustain a recovery without resorting to Japanese style monetary policy. Mark Carney has managed to skilfully avoid a crisis thus far, but the capital flight from the UK must now be causing him concern. Even London property is stalling out[xlii]; which is a sure sign that capital is becoming scarce.
“It’s Grim Down South.”
A recent Guardian survey found that at least one third of UK mortgage borrowers, most of whom live in the South and presumably vote Conservative and/or UKIP, would be seriously impacted by a rise in interest rates[xliii]. This was taken to mean that the Bank of England will not raise interest rates for some time, by those with no imagination and no memories of 1992.
“Been There, Bought the T – Shirt.”
If however Sterling starts to slide, because interest rates are expected to stay low and capital then flies to America, the capital markets will force a rise in UK interest rates, in order to fund the huge budget deficit and falling currency. A “Brexit” from the EU would only accelerate the capital flight and the corresponding risk premium demanded by Sterling holders.
Against this backdrop, the said “at risk” UK mortgage borrowers would realise their worst fears. The latest UK house price data shows that the rest of UK property is rising whilst London is falling[xliv]. This confirms that capital is leaving the UK, because risk adjusted interest rates are too low; and also a domestic picture which evinces rising inflation in house prices outside the capital. Clearly those “Provincials”, who do not feel threatened by a hike in interest rates, are driving the housing inflation which threatens those in the South.
It is possibly the first time that the Bank of England and a Tory Government have ever prioritised the rest of the country over London. Could this also be part of the “Northern Powerhouse” strategy to buy some votes? The Tories and Carney are really gambling with Sterling. First they undermine it with deficit threatening tax cuts; and secondly they allow a property and inflation bubble to grow. Will they be able to get away with it this side of the General Election? The odds don’t look good, given that capital is already flying over to America where the interest rates look better and the risk from the Eurozone looks smaller.
“It is more likely than not that I will have to write an open letter to the Chancellor in the next six months on account of the inflation rate falling below 1 per cent”
“Today’s Fish and Chip Wrapper.”
Carney has just been served notice that it will soon be time to realise the sum of all these fears. His record on guidance is about as good as that of James Bullard. Initially, when he moved into office, he guided the markets to expect that Britain would be the first into the tightening cycle. Back in September, he was preparing householders for the inevitable rise in interest rates, because unemployment was falling and wages were rising just as they are today.
Today unemployment is falling and wages are still rising, yet he has decided not to raise rates. He was able to neatly avoid perjuring himself, when the growth data suggested that the economy was not strong enough to endure rate increases, by blaming the weak global backdrop especially in the Eurozone.
Last week the Bank officially guided that interest rates should remain low, because inflation is low even though unemployment is falling rapidly. Carney went on the record that he will soon probably have to write an inflation letter to the Treasury explaining why inflation is below 1%. The Bank is simply forecasting the data to fit Carney’s desires for the path of interest rates. For Carney’s desires on the path of interest rates, read Osborne’s desires for the path of interest rates. Carney has therefore confirmed that he is the politically dependent Governor of the “independent” bank of England. Growth was forecast lower for 2015 and 2016[xlv] by the Bank.
“UK Pay Always Leads the Way, Both Ways.”
The problem is however that wage increases have just increased above the level of inflation, for the first time in four years[xlvi]. George Osborne has unfortunately found that these higher wages are insufficient to drive the income tax revenues, needed to address the ballooning budget deficit, as high as are required. To compound matters, David Cameron has just committed to election gimmick tax cuts, which have made the deficit situation even worse. With wage inflation just crossing above headline inflation and with unemployment falling, Carney has the beginnings of an inflation problem; similar to the one building up for Janet Yellen.
Carney has however signalled that he is going to let the inflation problem slide, by keeping interest rates on hold. With no prospect of the kind of interest rate premium that Janet Yellen is offering, Sterling is in danger. As it slides, the inflation problem will get even worse. Ben Broadbent drew attention to this problem last week, with some coded language on British productivity starting to improve gradually[xlvii]. Broadbent hopes that the speculators will read the improving productivity as Sterling positive. In his hopes, rising wages will beget increased consumption and hence economic growth.
There is however the risk that retailers simply raise prices higher than the increases in wages. The high street price war has now reached a level of attrition at which retailers are going out of business; so it is unsustainable and those who survive will increase their pricing power.
When David Cameron’s tax cut beneficiaries take their new found purchasing power to the shops, they will find that it has already been stolen by inflation. The problem for Broadbent is that his signals on productivity do not fit with the Bank’s official projections on growth. The Bank just forecast lower growth for 2015 and 2016, however the recent wage data and Broadbent himself suggest that this lower growth will be accompanied by higher wages. This inconsistency should trigger all kinds of bells in the Forex community. There will therefore be no increase in productivity, if the growth forecasts and what he says about rising wages are both correct. All that Broadbent has done is to serve his master’s interest rate agenda, without providing a coherent rationale for this absurd behaviour.
“Yesterday’s Fish and Chip Wrapper.”
Nemat Shafik and Ben Broadbent must be having some interesting discussions these days. In September, when their boss was leaning towards tightening, she opined that:
“If wage increases are expected but productivity is performing well we can wait for longer; if those wage increases are not accompanied by productivity increases then I think we will have to move more quickly on rates because inflationary pressures will build up.”
Presumably she will soon be opining that productivity is performing well.
“Tomorrow’s Fish and Chip Wrapper.”
How long these three can play the game, until the markets call their bluff, should make for interesting reading between now and the General Election.
“Capital Exit Wounds.”
The European predicament, in relation to capital flight to America, is even worse than Britain’s. Europe continues to be the place not to invest[xlviii]. Germany believes that economic reforms will ultimately attract investment back.
Matteo Renzi’s much heralded economic reform is either not working, or has not started; or both of the above in Italy. The rate of company formations in Italy for Q3 was the lowest on record and company closures continue to accelerate[xlix]. Political certainty would be a good base for an economic recovery ; but as the economic crisis (and German behaviour) pushes the Eurozone towards a break-up, there is no political certainty whatsoever. The current Eurozone version of the Kristallnacht, in relation to German attacks on its institutions and personnel, only provokes the uncertainty. Into the uncertainty, anti-EU nationalist parties are beginning to fill the political void. Arthur Mas repeated his call[l] for a formal referendum and negotiated withdrawal of Catalonia from Spain last week.
“Begin the Beguine.”
In Spain itself, the Spanish bearded telegenic version of Beppe Grillo and his Five Star party gained traction. This new populist movement named Podemos[li] is headed by a young economist called Pablo Iglesias, whose popularity is rapidly eclipsing that of the famous singer who shares his surname.
America’s strong Dollar strategy has been enforced, by its global opponents; which means that it has occurred at a moment which is not of America’s choosing. In military terms, a tactical victory is defined as forcing an opponent to do something he/she did not chose to do. America has therefore had a tactical defeat; which it is now trying to turn into a strategic victory. Obama and Yellen would have preferred to have gone into tightening mode after the Helicopter had transferred wealth and consumption power to the Middle Class; but this was not to be, thanks to China and the Midterms. The risk now for America is therefore that it is tightening before the economy has reached a sustainable growth path. The infusion of global flight capital, may provide the illusion of success; and may even stimulate some economic growth once it leaks into the real US economy from the capital markets. The illusion will however be transitory.
ECRI's WLI Growth Index
One cannot help noticing, that America is going into tightening mode just as the economy is starting to show signs of weakness; especially in housing[lii] and in cyclical growth rate terms[liii]. The housing foreclosure rate spiked[liv] and economic activity have slowed in advance of the point when the Fed formally ended QE. The Fed is therefore tightening well after the economy has started slowing. The Fed has been forced to wait too long before tightening, because the ECB has not followed through with a stimulus of its own. Now the ECB stimulus is misfiring just as the Fed exits. In addition the Fed tightening will ultimately lead to inflation of its own as capital flies into America. Rising inflation, followed by the interest rate increases which it causes, will be the finally brakes on any economic activity in America. Whilst the market consensus is for Deflation, the wise contrarian should now be betting on Inflation.
One cannot help noticing that early inflation indicators are starting to flash in the bubbly capital markets. If the flight capital coming to America leaks into prices in the real economy, rather than into job creating investment, then the Fed will find that it has to tighten into a weakening economy. The previous “Taper Tantrum” will therefore look like a polite rebuke in comparison to what then follows.
“Do Not Adjust Your Screens. Adjust Your Trading Positions.”
José Viñals , the IMF’s top financial adviser ,recently warned that risk taking had got back to its 2006 vintage bad old ways; and that whilst central bank liquidity was egregiously higher now, than during the Credit Crunch, capital market liquidity was significantly worse[lv]. Policy makers’ fascination with tightening capital adequacy rules to avoid creating another TBTF scenario has therefore failed.
In fact it can be rationally posited, that the actions of regulators have raised the cost of capital for market makers and lenders, so high as to trigger another systemic liquidity and credit crisis. Cynically, we believe that central banks have played along with this game, in order to engineer the next crisis; so that they can own the majority of the assets in the capital markets and totally disintermediate the banks.
Currently banks are only funding schlocky legacy assets and paying massive fines to customers who have been defrauded and manipulated; so they are no longer in the lending game. In the absence of this important constituent of the real economy, the central banks must therefore become the lenders of first as well as last resort. Said central bankers will also be asked to enable the transfer of wealth from the Asset Rich to the Middle Class, if and when called upon as a consequence of this next crisis of their making. David Levy, the grandson of the prescient forecaster Jerome, who forecast the panic of 1929, now sees the chances of US recession in 2015 at 65%[lvi].
The bullish economic forecasters are extrapolating the positive impact of the capital flight into US economy much further than the Jerome Levy Forecasting Centre’s cut-off point. The Helicopter will have to land in 2015, in order to bail these bulls out. Such prescient forecasting as Levy’s, is historically associated with a bubble in a major asset class; which then becomes the symptom that is indistinguishable from the cause for most observers. In 1997 it was Emerging Markets, in 2000 it was Technology and in 2008 it was Housing and possibly also China.
“There Will Be Blood.”
This time around, the US Shale industry looks like the most obvious candidate. During the period of QE and the Zero Bound, financial capital was misallocated to Commodities, especially energy; and investment capital was misallocated to mining and drilling projects. Prospectuses, promising the kind of returns associated with previous asset class bubbles, have been used to build up the oversupply of capacity in the Shale sector. American energy independence is therefore an illusion, courtesy of the Fed.
Fast forwarding to today, when it appears that Saudi Arabia is determined to take out the American Shale industry[lvii] and the Iranian economy in a price war, the price of Crude is now at a level which makes a large percentage of the US Shale reserves uneconomical[lviii].
The Saudi’s may also wish to send president Putin a strong message about supporting Assad and Iran. President Putin signalled that he has got the message last week[lix]; and was at great pains to signal that Russia is prepared for the Saudi’s to do their worst to the oil price.
The lower cost US Shale producers still refuse to yield market share, to either the Saudis or Putin; so they have not cut back production[lx]. Since global economic activity remains weak, the demand is not there to balance the Saudi’s aggressive selling. The Bakken Shale is the lowest cost reserve in America at around 45-47 $/barrel cost of production. The oil price can therefore fall all the way, to at least 50 $/barrel, before the Bakken is made uneconomical.
Saudi production still remains economical at this price, so presumably 50$/barrel is the top of the new trading range, that is currently in price discovery mode. The Shale Bubble is therefore bursting, as a consequence of this price discovery. It will not take long for the more celebrated analysts to begin opining that the falling oil price is a signal of recession; and the prophecy then becomes self-fulfilling.
“There Will Be Blood on Wall St.”
The global oil majors, who play the long game and have been relatively circumspect during the Shale Bubble, must be waiting in the wings; ready to start consolidating, when the collapse in valuations starts to look like a classical capitulation phase. Halliburton and Baker Hughes aren’t even waiting for the great consolidation to threaten their profit margins; and have already allegedly started discussions over a merger[lxi].
As the upstream and downstream oil companies know and as the IEA has opined, the size of the Shale Bubble is concealing the fact that most of the world’s economically viable hydrocarbon supplies are located in regions which have geopolitical supply constraints[lxii]. When the bubble bursts, it will be time to deal with this inevitable reality again.
This is presumably why the IEA also opined the embrace of renewables and nuclear power, in order to mitigate the problem of dealing with the constrained hydrocarbon reality in the new age of CO2 emissions targets[lxiii]. Perhaps however it makes more sense to begin at home in the consuming nations, which currently subsidise their hydrocarbon energy industries to the tune of $ 550 billion annually[lxiv]. This huge subsidy bill is funded by consumers and taxpayers; and dwarfs the current level of renewable energy subsidies.
If this tax were removed, it would be a much more potent economic stimulus than anything the central banks have achieved to date; because it would go directly into consumers’ pockets. Before this notion is considered seriously, by the electorate in western democracies however, oil must fall back to levels which make the huge subsidy and the costs of related military adventures, to secure its supply, look like good value for money once more.
By the end of last month, on the eve of the G20, it was evident that the “Taper Tantrum” of old was at risk of breaking out again. The OECD applied pressure on all members to expand their stimulus plans[lxv]. Janet Yellen started to weaken the bid that the Fed has created for the US Dollar, with a speech which emphasized the Fed’s international obligations to support growth[lxvi]. Speculators were therefore prompted just to focus on the end of QE, rather than the beginning of the interest rate hike cycle. The damage had unfortunately been done however. The Europeans are now headed towards a scenario which will prompt Yellen to start talking in terms of easing, if Germany refuses to become more American. Yellen’s problem, like Carney’s, is that she is now in a race against inflation.