The Delusional Crowd
Age of Wisdom, Age of Foolishness (56)
“Add your voice to the sound of the crowd.”
The proverbial crowd was busy all over the world the last few weeks, being delusional and creating the illusion of a lynch mob in the specific localities where it was to be found.
D U D L E Y
The resurgent GOP is now closing in on the hapless Fed. Bill Dudley did little to keep the hounds at bay in his most recent Senate Banking Committee appearance[i]. Based on this performance, not only do the lawmakers sense that the Fed has something to hide; but they also smell blood. The New York Fed leader is not a Presidential nomination; he is nominated by the commercial banks which make up the Federal Reserve System. It is therefore here that the lawmakers smell the insidious nexus of self- interest, between the supervisor and the supervised, because the supervised actually nominate their supervisor. The New York Fed thus represents the weak point in the Federal Reserve’s defence of its autonomy.
Age of Wisdom, Age of Foolishness (55) “Yes Virginia ….” explained how the metaphorical knives were out for Mario Draghi, after he crossed the Rubicon on the verboten subject of government deficit monetization. In order to appear to follow due process, before he is condemned, the EU went through the motions of presenting an alternative economic plan to Draghi’s last week.
This alternative is a cannibalization of other budgeted EU investment expenditures, so that no new net spending or borrowing occurs. By some miracle the EU thinks that, if it puts down 26 billion Euros in seed investment and bank guarantees that, the private sector will then put up ten times this amount in order to fund capital investment[ii]. The EU has clearly overlooked the fact that the tighter Basel III capital rules, that it endorses, have priced the banks out of the lending game.
It also ignores the fact that no private sector investor or lender would put money down in an environment where the breakup of the Eurozone is becoming the most probable outcome of the political infighting currently underway.
An Australian Constitutional Crisis was envisioned in Age of Wisdom, Age of Foolishness (55) “Yes Virginia ….”, as a consequence of the insidious colonial backlash against Tony Abbott’s strategy of moving the Antipodes into the Chinese sphere of influence, with the landmark free trade deal at G20. Last week, the first signs of the unfolding crisis emerged as Jacqui Lambie[iv], the senator for Tasmania, withdrew her support for Clive Palmer’s party which is the kingmaker in the Abbott reign.
For those looking for the hand of the perfidious Albion in the plot, a similar modus operandi recently used by the Scots to gain greater independence, was very evident in the tactics employed by Lambie. If Tasmania were to leave Australia, it would then become more of a Commonwealth country as Australia drifts towards becoming a republican satellite of the Peoples’ Republic of China.
It seems that Tony Abbott will now pay a heavy price for frustrating America’s “Pivot”, by challenging its own Trans-Pacific Partnership (TPP) trade deal for the Asian region. Going forward, the Aussie Dollar may even prove to be weaker than Sterling; which is also entering a political storm of its own.
“Brace Yourself Bridget … for an Aussie Dollar Crisis.”
Ostensibly, if one is to fall for the sharp rally in Chinese equity prices, following the recent move by the PBOC to cut interest rates, Tony Abbott has made a smart move. The devil is always in the detail however. On closer scrutiny, the cut in interest rates appears to be yet another bail out for the banking system that is exposed to the State Controlled Enterprises (SOE’s)[v]. It is thought to be unlikely that the Chinese banks will pass on any of the recent fall in benchmark borrowing costs to their current or future borrowers[vi].
Depositors however, got a big reprieve when the PBOC announced that, only bank lending rates would be reduced basis the lower benchmark rate and, deposit rates would remain the same. At first blush, this looks like a crude attempt to stop a deposit run on the banks. In practice, it means that one can make a run on the banks by borrowing at reduced interest rates and then moving the money into more attractive liquid assets, or abroad into the US Dollar. Depositors, who may think that they are safe, will at first watch in horror for a moment as the PBOC enables this arbitrage by lowering the deposit to loan ratio for the banks.
“There are lies, damned lies, statistics and then Chinese Whispers.”
Just to make them feel a little safer Sina.com ran an unconfirmed story, from an anonymous source who alleged that depositor insurance will arrive next January[vii]. To embellish the tale, the Deputy Governor of the PBOC opined that the recent easing moves were prompted by falling inflation. Following this noble lie, the latest industrial profits data revealed the kind of plunge that central banks ease policy for and then justify with talk of falling inflation[viii]. Once satisfied that their deposits are under attack, a traditional run by the depositors will ultimately ensue.
The recent squeeze higher, in Chinese equity markets, is therefore nothing more than a knee-jerk re-pricing of the fact that cash in not king. It is clearly not justified by the corporate profits picture; therefore a bubble has been created. It is also a symptom of the kind of frenzied trading activity that has been observed at the significant market peaks in 2009 and 2010.[ix] A further re-pricing of the fact that Chinese cash is not king, will then see Chinese shares and cash dumped for US Dollars.
“The Great Demographic Wall of China.”[x]
Abbott’s real mistake is that he has hitched the Australian economy to a Chinese economy which is just hitting the demographic buffers[xi]; which are a consequence of the “One Child” policy. From here on out, China ages rapidly; which means that the labour force contracts rapidly. There will therefore be wage inflation, which is bad for Chinese equities and the economy in general.
In addition, there will be none of the youthful consumption that the economy needs to grow at above average rates to get out of its debt problems. The Chinese government will then have to decide who to save; the pensioners or the young minority which is supposed to carry this aging demographic burden.
Age of Wisdom, Age of Foolishness (18) “Beyond the Pale”[xii]
Age of Wisdom, Age of Foolishness (18) “Beyond the Pale”[xiii] synchronised the geopolitical clock, for the events in Ukraine and the Middle East, with Prime Minister Netanyahu’s visit to America. This synchronicity remains constant. Last week, Chancellor Merkel found herself in the position of having to say no to Ukrainian pretentions to join NATO[xiv]. She may however find that the application is received with the overwhelming approval of the US Congress; which then puts even greater strains on relations between Germany and the US.
“Nothing Could Come Between Them!”
France is already feeling the pressure of trying to walk a fine line, between the rapacious Russians and the pretentious Ukrainians. Having sold its Mistral warship to Russia, France is now holding back delivery whilst trying to objectively criticise both sides of the conflict[xv]. An American clash with Germany, over NATO membership, should soon occur.
“Oh Give me a Dome,
Where the Israelites Roam.”
Also earlier this month, whilst the P5+1 laboured over their negotiations with Iran, Israel was hard at work on its own political agenda; which vitiates against the negotiating process. Netanyahu’s cabinet agreed on a “Single State” solution; that effectively disenfranchises the indigenous Arab citizens, whilst allegedly affording them equal opportunities to seek legal justice[xvi]. This solution will now go to the Knesset for approval. Should it become the law of the land, many of the indigenous Arab people affiliated with Hamas will then violently react. At this point, since Iran is aligned with Hamas, the whole situation has the potential to blowback into the current P5+1 negotiations.
In Age of Wisdom, Age Foolishness (54) “Taper Tantrum Redux” America’s prioritization, of a nuclear agreement with Iran, was observed to be placing constraints upon Israel’s priorities. Israel has therefore broken free of all these constraints and unilaterally undermined American foreign policy priorities. President Obama’s constraints, applied by the Republican led Congress, provided the window of opportunity for Israel to break free.
“Obama Don’t Surf.”
President Obama has assumed the demeanour of the lame duck with great aplomb, since his second Midterm “shellacking”. He now considers it prudent to talk in terms of the next President, rather than what he intends to do for the remainder of his own presidency. The code word “Change” has been dropped from his lexicon, in favour of the evocative words “new car smell”[xvii]. Apparently this odour has a strong hint of Hillary Clinton; although President Obama was careful not to give her the kiss of death by directly endorsing her. What this signals, is that there is now a foreign policy vacuum existing until the next administration. It may also be that current policy is designed to avoid taking any serious initiatives; thus preserving what remains of Obama’s shaky legacy. America’s adversaries will take heart.
They will no doubt also take heart from the forced resignation of Defence Secretary Hagel[xviii]. Before reading Hagel’s obituary, one should get some real perspective by reading his piece entitled a “Republican Foreign Policy”[xix], in the July/August 2004 edition of the Foreign Affairs publication from the Council on Foreign Relations. Readers should remember that “W” was “shocking and awing” in office at the time; and also that the Democrats were searching for their own foreign policy and their own presidential hopeful to deliver it. Hagel opined that the Republicans should have the following seven pillars of wisdom:
- “First, the United States must remain committed to leadership in the global economy.”
- “Second, U.S. foreign policy cannot ignore global energy security.”
- “Third, the United States' long-term security interests are connected to alliances, coalitions, and international institutions.”
- “The fourth principle of a Republican policy should be that the United States must continue to support democratic and economic reform, especially in the greater Middle East.”
- “Fifth, the western hemisphere must be moved to the front burner of U.S. foreign policy.”
- “Sixth, the United States must work with its allies to combat poverty and the spread of disease worldwide.”
- “The seventh and final principle of a Republican foreign policy is the importance of strong and imaginative public diplomacy.”
He then went on to opine specifically on China that:
- “The challenge for the United States today is how to ensure that China stays on the path of normalization and stability.”
- “First, China's role and influence will be critical in helping contain the nuclear ambitions of North Korea.”
- “Second, China will be instrumental in global efforts to reduce proliferation of missile and dual-use technologies.”
- “Third, the United States supports the peaceful resolution of differences between the People's Republic of China and Taiwan.”
The “Pivot” can therefore be inferred by reading between the lines on China.
“It’s Pantomime Season Boys and Girls.”
On reflection, it would seem that President Obama’s foreign policy has been directly lifted from what Hagel wrote back in 2004. It is therefore no surprise that Hagel was made Defence Secretary, since his ideas became plagiarised in what has been called “Obama Doctrine”. The President may also owe his premature Nobel Prize awarded as he had just entered office, in advance of his expected work on nuclear proliferation, to the pillars of Hagel’s wisdom. Certainly, Arab Spring looks very similar to Hagel’s fourth pillar above; and the first pillar was clearly the whole point of the Bailout, then QE and now the most recent strong US Dollar policy. Pillar two incorporates the Shale Oil bubble, in addition to Arab Spring and the current situation in the Middle East. Pillar five is all about the Eurozone and Russia. Pillar seven is presumably the “Change” that we could all believe in; and now wish that we had never heard of.
Hagel’s crystal ball was a very clear one, back in 2004, when he wrote his prescient historiography. It has been said that Hagel became increasingly frustrated by his lack of access to the President; and also his own constrained authority to execute a strategy which it is clear that he understood as far back as 2004. More worryingly, his forced resignation suggests that the “Hagel Doctrine”, plagiarised by the Obama administration, has now either been altered or more likely held hostage by the GOP. For allies and adversaries alike, a significant discontinuity in American foreign policy has occurred; which signals risk and opportunity for those who wish to play in the vacuum.
The P5+1 negotiations with Iran are obviously a hostage to the Republican control in both houses. Given this Republican constraint, it is therefore not surprising that the President tried to claw back some ground for himself at the expense of the Pentagon and Secretary Hagel. Faced with a lame duck commander-in-chief and an eroding franchise, at the hands of both the commander-in-chief and the Congress, it is hardly surprising that Hagel jumped. Who would stick around to deal with this mother of all SNAFU’s?
“There’s no place like home.”
Indeed Michele Flournoy, the alleged favourite to replace Hagel, didn’t fancy it[xx]. In light of these developments, it was interesting to observe the cool diplomatic heads on both sides of the P5+1 negotiations; dealing with the latest speed bumps by prolonging the negotiations to allow more time and space to reach a compromise [xxi]. During this cooling off period Oil prices can fall to $40/barrel, the Republicans can erect more Iranian sanctions, Israel can declare its fiat “Single State” and Iran can continue developing its nuclear technology in secret. An opportunity has been missed; and the stakes have been raised to levels which make a future deal even less likely.
Value investors are struggling with the apparently conflicting signals from US credit markets and equity markets. There is however no conflict at all. Credit spreads are widening in anticipation of a Fed tightening. US equities are rallying because the capital flight from spread product, including global markets, is headed for US equities. Any future uptick in inflation is also viewed as better for US equities, than spread product and any other global risk asset class. Those who believe that higher US interest rates will eventually cause another violent sell-off in US equities should think again.
The widening of credit spreads has already begun to hit the real US economy. Going forward, any near-term economic strength from the influx of global flight capital will be followed by medium term economic weakness; as the wider credit spreads take their toll on the real economy. Once this ensuing weakness shows up in the data, the data-dependent Fed will then be under pressure not to tighten and ultimately to ease again. The expected crisis in the Eurozone will only accelerate the capital flight into the US and then the headwind which puts pressure on the Fed to reverse its tightening bias. Any dip in US equities, which may appear between now and the reverse of the Fed’s tightening bias will therefore be shallow, short-lived and well bid.
“Gothic is the new TBTF.”
Of the bond credit risk spread, that the bears are currently so excited about, it is interesting to note that the vast majority of it is now concentrated in the hands of only twenty global fixed income uber-asset managers[xxii]. This is presumably where most of “Mom and Pop’s” savings and pensions are held. The immediate reaction is to suspect that the Fed and policy makers are going to do a number on these assets under management; in order to pass on the interest rate and inflation risk, as the Fed’s balance sheet shrinks back to normal.
This may indeed be the motivation; however the reality is the total obverse. These new twenty systemically important institutions, which are TBTF and could take the global economy down, have therefore appeared on our radar screen. Basel III and Dodd Frank have however put the commercial banks out of the lending business. Policy makers and the Fed therefore need “the Twenty”, in order to create credit and to exit QE respectively.
“The Twenty” therefore now call the shots; so the policy makers and the Fed must do everything that they demand in order to continue to keep them buying bonds. As the global economic cycle moves from the need for austerity into the need for fiscal stimulus, “the Twenty” will come into their pomp. At this point they will call the shots. As usual, the Washington lynch mob, that currently has the noose around Bill Dudley’s neck for allegedly being in bed with the banks, is looking in the wrong place and fighting the last war. The new conflict has already been won. The real bond vigilantes are the new villains; and their number is “Twenty”.
The Eurozone crisis is progressing nicely. Last week the ECB’s Benoit Coeure tried to sweep the discontent under the carpet, by referring to the conflict between Weidmann and Draghi as a discussion. According to Coeure, no decisions have yet been made on which assets will be bought and what the time frame for the next buying programme will be[xxiii]. Weidmann was much more unequivocal however; and left no one in any doubt that he believes that Draghi is now acting illegally, by attempting to monetize national deficits[xxiv].
Victor Constancio was able to sell this to the eager bulls, with the qualification that the government bond buying will be done in proportion to each country’s GDP[xxv]. In practice, this means that the lion’s share of QE will end up back in Germany via German Bunds. Perhaps Constancio was offering this as a bribe to Germany.
The principle is absurd, because it means that QE will end up in the economy which needs it the least; and will not go to the economies that need it the most. One suspects that France will be happy with this outcome, because the French economy is weak and also second in size to that of Germany. France will get some much needed QE as a consequence of its size. With the exception of France therefore, the divergence in economic performance across the Eurozone will get even worse, as a consequence of Constancio’s plan.
There is then also the moral hazard issue; by which countries are encouraged to avoid austerity in order to maintain the size of their economies and hence the amount of QE that they can grab. Constancio’s plan therefore directly contradicts the Stability Pact and other deficit limit laws of the Eurozone. He may soon find himself in the dock with Draghi, when Weidmann brings his case to the European Court of Justice. In addition, under Constancio’s plan, Germany will get the influx of capital which creates dangerous asset bubbles and domestic inflation there.
To emphasize the absurdity, after Constancio spoke, German equities rallied one per cent whilst other European equities stood still. Age of Wisdom, Age of Foolishness (55) “Yes Virginia ….” suggested that the developing bubble in German residential real estate would soon trigger a response from the Bundesbank. Low interest rates, rather than increasing jobs and salaries, have finally got Italian real estate to move upwards for the first time in six years[xxvi].
“When inflation’s on the rise
You must whip it.”
“Age of Wisdom, Age of Foolishness (52) “Deathly Hallows”
The signs of an asset bubble, predicated on central bank liquidity rather than real economic growth, which is anathema to the Germans, is becoming clearly visible. The Bundesbank responded with alacrity last week, when it directly opined on the unsustainably inflated prices in the German residential real estate market[xxvii].
As was seen in Age of Wisdom, Age of Foolishness (52) “Deathly Hallows” the Merkel government is trying to constitutionally crackdown on the inflation transmission mechanism into real wages, with the Nazi’s old trick of banning trade unions[xxviii]. German unemployment just reached a record low last week, therefore wage pressures are building in the absence of skilled immigrants who are happy to undercut the natives[xxix].
Germany is therefore totally out of sync with the rest of the Eurozone, politically, legally and economically; so it begs the question why Germany is there at all. It also begs the question of who should pay for Germany’s membership of this group, for which it has no economic affinity. Thus far, the cost has been born by the other members; who are now finding this distribution inequitable and unaffordable.
“Le Cocteau Twins.”
France signalled that it has no intention of getting serious about economic reform, when Emmanuel Macron made it clear that the 35-hour working week and Sunday closing were non-negotiable. Germany and France are therefore now on a direct collision course.
“Hasta La Vista Baby.”
Spain signalled that it is suffering from the corollary of the German problem. According to the latest Spanish CPI figures[xxx], deflation has allegedly set in. This deflation is alleged, because in actual fact it feels like inflation to the majority of Spaniards whose compensation is falling faster than retail prices. The lack of economic activity in Spain also reduces the supply of goods and services, so that those that remain are still overpriced. In practice, this means that money will continue to leave the Spanish economy for the German economy; and presumably for the American economy also.
Constancio’s bond purchase plan will inject new money into the Spanish economy which can then promptly exit. Before the single currency, Spain would have let the Peseta slide to stimulate exports and then hiked interest rates to attract capital; the combination of both would then have balanced its books. Within the constraints of the Eurozone, Spanish living standards have to fall to levels seen in China in order to attract capital investment, since the ECB insists on making capital investment and saving in Spain unattractive with enforced low interest rates.
“She Who Laughs Last …...”
Age of Wisdom, Age of Foolishness (55) “Yes Virginia ….”
The OECD is beginning to get worried about Europe and the headwinds emanating there. Consequently it has already begun to beg the Fed to reverse the tightening decision; which is exactly what Yellen expected[xxxi].
Mark Carney also availed himself of the opportunity for lower interest rates afforded by the OECD and the Treasury Select Committee last week[xxxii]. In fairness to Carney he presented a balanced view to the OECD, by including both Kristin Forbes and David McCafferty in his presentation. Carney was of the opinion that the global headwinds justify a cautious approach to rate increases. McCafferty was more Hawkish and Forbes was as frustratingly equivocal as ever.
“Kumhoff it, pull the other one!”
As usual however, Carney has a more devious subterfuge behind his urbane demeanour. Ably assisted by David McCafferty[xxxiii], Carney totally destroyed the reputation for professionalism and integrity of the Office of National Statistics (ONS) last week. The alleged “garbage in” data produced by the ONS bean-counters is not good enough for the Bank of England to analyse and create effective policy any more.
“The KumHoff” Page 3 Selfie.
Carney has therefore justified his new appointment, of the shadowy former IMF economist Michael Kumhof, to become the Bank’s “hottest” bean-counter[xxxiv]. If one now hears a huge sucking sound on the grassy knoll at Threadneedle Street, it is a bye-product of the incestuous group-think conspiracy that is evolving there, rather than the Victorian plumbing in the building; as the institution cherry picks its own data to hit the Governor’s targets.