Yes Virginia - - -
December 16th, 2014
in aa syndication
Age of Wisdom, Age of Foolishness (55)
Coming out of G20 a couple of weeks ago, the message from policy makers was that Santa Claus still exists and will deliver record equity index closing prices for Christmas. Slightly less credible, were the stories that allegedly he will also deliver economic growth and low inflation. There were nearly 1000 growth requests on Santa’s G20 list this year, submitted by the wide eyed policy makers of the member nations[i]; which apparently add up to a $2 trillion global stimulus package[ii].
Speculators were inclined to discount the positive impacts, of the $ 2 trillion growth package, into asset price valuations as the week began. If all this money goes into capital markets, there will be no growth; and asset prices will therefore be even more inflated and unrepresentative than they are now. If all this money hits the consumer, there will be an inflation problem. If all this money goes into capital investment, there will be another oversupply of global production capacity with no demand in sight. It would therefore be premature to place all one’s bets on any specific outcome. In practice it is more likely that all the outcomes previously suggested will occur, but not in the sequence that the policy makers desire, thereby making the outcomes more volatile and more fun to trade; and even more fund to write about.
“Two Bulls on a Hill.”
The potential for fun and games is highlighted by the current market psychology.
“Buy the Rumour to Make It the Fact.”
September TIC Data
Pre G20, there was a strong consensus that the Fed will begin tightening between Q1 and Q2 of 2015. The strong bid for the US Dollar that this produced however, caused Yellen to pause on the eve of G20; and opine that she was aware of her obligations to global economic growth. Thus coming out of G20, the consensus is emerging that the Fed will allow for a little more economic growth because inflation is allegedly not a problem[iii]. Any young bull charging off down the hill, to discount this latest consensus on all the attractive assets, may wish to walk down and discount them with more singular attention. The big news being ignored, in the red mist, is that the Fed itself has just signalled that the young bull should stay at the top of the hill with his father.
“It's easier to fool people than to convince them that they have been fooled.”
Last week, the fed published a curious article entitled “Potential Output and Recessions: Are We Fooling Ourselves?”[iv]. The research concludes that recessions, especially deep ones, actually reduce the future economic output potential of the recovery.
Terminal Velocity (14) – “Goldilocks Economy and the Three Bear Markets”[v]
The Fed therefore, in principle accepts our view[vi] that QE simply pulls growth from the future. The borrowing of growth from the future, therefore reduces the future growth potential in the Fed’s words. The challenge for the Fed and the executive arm of government is therefore to increase the future potential economic growth. Economic reforms and technology and lower oil prices can increase this potential growth. Oil prices are falling, but technology is creating jobless growth. Even worse, policy makers are gridlocked, now that the GOP controls both houses.
“It Will Soon be Milking Time Again.”
Age of Wisdom, Age of Foolishness (26) “Milking It For All It’s Worth”
We have always suspected that Yellen and Lew were working on the Helicopter, to transmit a permanent increase in the money supply to the Middle Class via the tax code. The Lame Duck administration, that came out of the Midterms, has effectively stopped the Helicopter from taking off. In summation therefore; when the speculators start to analyse the Fed’s analysis, on the lower potential output gap, they will conclude that the Fed is actually behind the curve on tightening; because there is far less, of what is termed the output gap, available before inflation becomes a problem. What Janet Yellen said, about accommodating the global economy, then goes straight out the window; and capital flight charges down the hill into the US Dollar like the proverbial young bull. The problem with this however, is that all the money flooding into the US Dollar and US economy has less potential output to chase; so that it will create inflation in the real economy once it has had some fun in the capital markets. The inflation problem will then be significantly worse, as a consequence of market response to the perceived smaller output gap. Fun and games indeed!
“She Who Laughs Last …...”
Yellen of course already knows the outcome of all this. Once another US recession threatens, because of the markets’ reaction to the combination of potential rate hikes and inflation, Yellen will talk of the need to create greater future growth potential; by transferring wealth to the Middle Class consumer. The Helicopter will then have its day. Yellen hopes to get to the Helicopter without a US Dollar crisis. The Europeans and the Brits and the Japanese, are all making sure that she and the US Dollar land safely; by doing their level best to destroy the value of their respective currencies.
“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”)
Fed newbie Loretta Mester was first noted in Age of Wisdom, Age of Foolishness (54) “Taper Tantrum Redux”; tasked with the unenviable job of reforming and restructuring guidance, so that the Fed can exit QE without destroying the capital markets and global economy. Last week, it was her job to get the lawmakers in the hostile GOP controlled houses in Washington on board. Mester adopted the subtle tactic of positioning the new form of guidance as a form of Fed accountability[vii]. By making regular consensus projections, the Fed will in theory and practice become accountable for its decisions based upon them. In this way, the Fed intends to preserve its independence and licence to create credit.
Age of Wisdom, Age of Foolishness (54) “Taper Tantrum Redux” suggested that Germany was in the process of destroying the institutions and leadership of the Eurozone, in order to rebuild them in its own image. Simultaneously nationalist political groups, within the weaker Eurozone economies, were also observed to be doing the same thing as Germany; with the separate objective of rebuilding their own political autonomy. This process was smoothly catalysed, by the American adoption of a stronger US Dollar policy; that is sucking capital flows from the Eurozone.
“Borrowing, Spending and Printing Like Drunken Sailors.”
Whilst catalysing the destruction, America advocates that Europe adopts the American style of borrowing, spending and central bank money printing.
“The Seductive Economic Alternative.”
The case of Italy, classically illustrates the European problem. Since the recession, the Italian government has become the greatest customer and employer of its own domestic economic base[viii]. Italy is therefore just like Greece was, before it was bailed out, in principle and practice. In order to comply with Stability Pact guidelines, the Italian government must therefore maximise its own operating income statement and reduce liabilities on its balance sheet. In order to maximise operating income, it must accelerate the collection of receivables and delay the payment of payables.
Taxes are therefore raised and collected swiftly, whilst payments are minimised and delayed. The maximisation of receivables and minimization of payments therefore deprives the consumer of purchasing power and government supply companies of revenues respectively. The Italian economy therefore contracts, which then forces the government to become even more abstemious; which then creates a new round of economic downsizing.
A negative feedback loop has been created; but this loop has a finite lifespan. Since there is no Italian central bank to create the Lira in the form of inflation, which would keep the liquidity and economy functioning, admittedly with a lower exchange rate, there is no American, Japanese or British similar inflation option open for the Italian government.
Italy is therefore headed for bankruptcy and a bailout, the same way that Greece was.
The ECB on the other hand, is trying its best to make it look as though another round of bailouts is unnecessary. In bankruptcy, the viable arms of the state will be privatised and the rest will be liquidated. With the removal of the greatest economic driver, in the form of the government through reform and privatization, Italy will become dependent on low wages and exports to survive. Observers assume that this is deflation.
To Italians however it feels like inflation, because the price of everything is rising beyond their means; and the supply of everything is declining, because there is no pecuniary opportunity for producers to sell goods into the Italian market. Italians will then look longingly at the Americans, Britons and Japanese; who have cheated by allowing their currencies to fall in order to sustain exports and employment. Italians may then conclude that it is better to cheat than to abide by the rules of the Stability Pact. Germany will frighten them with the spectre of having debts in a stronger currency aka the Euro.
Italians may then judge that, if they have their own new currency and that it is low enough in value, they will be able to export enough to pay back their debts in Euros. Already many of them are voting with their feet and emigrating in search of work. The problem has become so bad in neighbouring Switzerland, that a referendum is being demanded on the subject by some; in addition to the national policy of the hoarding of Gold again[ix].
This thought experiment serves to illustrate the fact that, as the number of weaker economies that consider leaving the Eurozone increases, the risk for German exports and its economy also increases. By seeking to destroy the Eurozone as it exists today, Germany is also destroying itself. The removal of the Europhile elite, in the individual countries within the EU, by Germany will only accelerate this self-destruction.
“They’ve Bought the Rumour. Time to Sell the Fact.”
Investors have clearly bought Draghi’s promise to “do whatever it takes”; therefore the European capital markets indexes are discounting QE and also some fiscal stimulus, despite strong German words to the contrary from Weidmann and Schaeuble. Germany seems to have run its economic numbers; and decided that the cost of Eurozone destruction is worth paying. This scenario is clearly not priced in. If Draghi delivers, the result is already in the price of Eurozone assets today. If he isn’t allowed to deliver, said assets look very expensive.
Capital flight, within the Eurozone, has been exacerbated by the ECB’s policies to date and low interest rates in general. The latest German ZEW investor confidence survey signalled that positive sentiment finally occurred in October, after eleven months of declines. Attempts by German policy makers, to curb the enthusiasm for Draghi’s alleged QE and even fiscal stimulus, have been overwhelmed by the Anglo-Saxon press[x]. Germany is losing the control it has exerted over the Eurozone.
In a tell-tale early inflation signal, liquidity has already leaked from the German capital markets into the residential property market. German rents and residential property prices are now the highest that they have been in a decade[xi]. Germany would therefore like to see tighter monetary policy, to anticipate this nascent inflation. The Eurozone capital markets have thus far been a reservoir, in which monetary inflation has been hiding.
Now in Germany, it is apparent that this monetary inflation is leaking from the capital markets into the real economy to create price inflation. Germany seems to have run its economic numbers; and decided that the cost of Eurozone destruction is worth paying for the end of domestic inflation. Tighter monetary policy, in the form of higher interest rates, would however just pump more Euros into Germany; and make the inflation problem worse.
Tighter monetary policy in America, neatly solves Germany’s problem. Capital is sucked out of Germany and the rest of Europe, into America; so that it cannot do any inflationary damage to the Eurozone. This sucking of capital would however end any future economic activity in the Eurozone. This sucking of capital would also deflate the lofty prices in Eurozone capital markets. Eurozone bulls must now consider whether it is better to travel than to arrive.
“The Ying Yang Twins, Shake It Like a Salt Shaker.”
The old MIT Saltwater combination, of MIT alumni and the central banking fraternity, was in evidence soon after G20 broke up. Mervyn King opined that the ECB must do more to weaken the Euro, in order to help France[xii].
“More of a Panzerfaust than a Bazooka.”
This was then followed up by the bombshell from Marion Draghi[xiii]; in which he signalled that he is considering buying government bonds as part of his next policy initiative. With these words, Draghi signalled that he is crossing the Rubicon on the “verboten” subject of deficit monetization. No doubt this form of deficit monetization is exactly what Mervyn King had in mind; since there is nothing that makes a currency fall harder than the news that the central bank is buying its own government’s bonds. Draghi’s smoke signal should be enough to trigger a massive negative response from Germany; and a counteroffensive against his own position.
The counter-offensive was immediately initiated by Weidmann, following Draghi’s signal, when he opined that Draghi will create moral hazard[xiv] if he embarks on government bond purchases. Draghi then met fire with fire; and responded to Weidmann with the anathema that the ECB must increase inflation as soon as possible. The level of brinksmanship has now become reckless on both sides[xv].
“Get Over It.”
Super Mario however faces a more serious obstacle, to his QE intentions, in the form of the BIS. On the day that he was creating inflation in Eurozone asset prices, with his words about creating inflation in the real economy, the BIS opined that it is tightening the capital adequacy rules in relation to Asset Backed Securities (ABS)[xvi]. By doing so, the supply of ABS that the ECB can potentially purchase has been diminished; and hence so has the scope of the QE based on these securities. Draghi will therefore have to go all out and buy government bonds, thus heading for a showdown with the Germans and ECB lawmakers over what defines deficit monetization.
“Carry on Draghi.”
Depending on one’s perspective, Draghi’s signal is either very good or very bad news; there is nothing in the middle however. His timing is similarly divisive, since he spoke on deficit monetization, just as the EU members are failing to agree a budget for next year; and are arguing over currently unpaid bills and future savings[xvii].
“The Troika is Losing Its Marbles.”
Greece for example, is currently in the final phases of delicate negotiations with the Troika over its bailout[xviii]. Draghi has therefore effectively undermined the Troika. In fact he went further and even opined that Greece has made great progress to date on its reforms[xix]. If Draghi is offering to buy government debt, just as these budget talks are in process; clearly there is an incentive for the more indebted weak economies to procrastinate. Presumably this is the moral hazard to which Jens Weidmann refers. Draghi is being political again, which will put him right in the firing line from Germany.
“Dutch Emergency Survival Kit, on the Shelves Ready to Go.”
The situation is so inflammatory that the Netherland’ Finance Minister Jeroen Dijsselbloem felt the need to remind the capital markets, that it has a plan in place should the Eurozone and its currency fall apart[xx]. Unsurprisingly, the new Dutch solution is the old solution; which was put in place back in 2012 when Greece triggered the system. The Dutch are clearly falling into line with Germany. Klaas Knot, the Dutch member of the ECB Governing Council, seemed to be reading from a script written by Weidmann; when he opined[xxi] that he was sceptical about the benefits of QE.
“Good as Gold.”
Although not a Eurozone member, the Swiss are already trying to create contingencies; in the form of immigration controls and the stockpiling of Gold[xxii] for the coming crisis. History sounds like it’s rhyming again rather than repeating exactly. Germany has prepared for the next crisis, by creating a budget surplus to safeguard its credit rating and its new currency. Holland is going to try and wing it with its deficit and a plan dated 2012 rather than 2014. The Dutch are living in the past and the present is far more dangerous than it was back then; because this time the Fed has ended QE.
The post- G20 reaction from Japan, signals that the threat from the Eurozone and the Fed is being taken very seriously. Abe swiftly postponed the next Sales Tax increase and also called for new elections[xxiii]. He clearly feels the need to get ahead of current events, with a new political mandate to continue his policy before the Eurozone falls apart. BOJ Governor Karoda has anticipated the outcome of Abe’s political brinksmanship, by increasing his voting majority to 8 to 1[xxiv]; so that he will be in an unassailable position to deliver the monetary stimulus being signalled. “Mr Yen”, fully cognisant of the extreme dynamics that this combination of events is having on Yen weakness, swiftly verbally intervened last week[xxv]; to decelerate the slide in the Yen which was starting to become dangerously uncontrollable.
"The greatest screen entertainment of all time!"
At G20, Chancellor Merkel made a big song and dance[xxvi] about retaining Britain as an EU member; allegedly because Britain brings a global perspective to an introspective continent. Germany would thus prefer to be seen as trying to support the EU, despite the fact that it is knocking down its current institutions and personnel. Immigration and foreign policy are obvious areas where Germany and Britain have mutually reinforcing interests. Germany and Britain see eye to eye on the need for EU reform; although it is unlikely that Britain would like it to become more Germanic, so the common ground is very limited. Because of its poor historical foreign policy track record, Germany would prefer to see Britain leading EU foreign policy initiatives; especially since relations with America have fallen to all time post-War lows over cases of American spying.
“On the Second Day of Christmas…..”
The Bank of England appears to be delivering its Christmas cards early this year. Over the G20 weekend, Governor Carney confirmed that he will ignore the early signs of UK inflation; and instead informed that deflation is his biggest worry[xxvii]. Anyone, who has had experience of Carney’s guidance, should prepare for the opposite outcome of whatever he says; based on his poor track record to date. Chief Economist Haldane overdid the semantics in his Christmas card, with the simile that he is watching the inflation data “like a Dove”.
The slide in Sterling, which is already well underway, is the metaphorical inflation signal that they both have missed. George Osborne needs this inflation, to print his way out of Britain’s ballooning trade and budget deficits. Age of Wisdom, Age of Foolishness (54) “Taper Tantrum Redux” suggested that the Bank of England was courting disaster, by ignoring the early signs of inflation. The latest early Christmas missive confirms that this is indeed the case.
“And a Sterling Crisis in a Pear Tree.”
The darker flip-side of the Pound coin was evinced by a cryptic festive message from Kristin Forbes[xxviii], after Carney and Haldane had fluttered their wings earlier in the week.
“The One Handed Economist.”
Age of Wisdom, Age of Foolishness (48) “Alpha and Omega”[xxix]
As we saw in Age of Wisdom, Age of Foolishness (48) “Alpha and Omega”[xxx], Forbes is the Bank of England official who is losing the most sleep over Sterling and inflation. Her professionalism forces her to try and call it the way it is; but her loyalty to the team obliges her to sugar coat it. The more she speaks however, the more attention she draws to the fact that something has to give. Whilst trying to emphasize that a “Sterling Crisis” is a thing of the 1960’s, Forbes had to admit that tighter global capital conditions would make funding the UK’s expanding current account deficit very difficult.
Reading between her lines, one can see Osborne’s election giveaway budget ballooning the budget deficit. The proceeds of this fiscal giveaway then fund a UK consumption binge, which sucks in imports and balloons the current account deficit. The party will be great, but the hangover will be fatal for Sterling and UK interest rates. By then, Cameron and Osborne hope to be home and dry back in office. If they call the election during the party, they just might get lucky. But then again, this is Sterling; and it is never found in the same sentence with the word lucky.
“Seven Black Swans a Swimming”
The latest MPC minutes suggest that luck is already running out.
“Two Hawks a Hawking.”
The 7-2 split, to keep rates unchanged, came with the big warning disclaimer that spare capacity is running out in the UK economy, thus raising the risk of inflation[xxxi]. It appears that the UK is suffering from the same kind of hollowed out potential future economic capacity that the Fed has recently warned of. If anything it looks like the UK, with a much smaller economy and landmass than America, is actually ahead of the cycle in terms of the declining output gap. If this proves to be so, then UK interest rates should actually be going up ahead of American ones. Unfortunately, Carney and the MPC have signalled that this will not be the case.
“Today’s Fish and Chip Wrapper.”
Age of Wisdom, Age of Foolishness (54) “Taper Tantrum Redux”
As we already know, Mark Carney has staked his dodgy reputation on his ability to prevaricate for long enough; with low interest rates for Cameron and Osborne to make a dash for the polls. If Kristin Forbes votes with her heart as well as her mind going forward, the next split could easily be 6 -3; at which point all bets are off because the 50/50 risk-return profile is too risky to call. Osborne and Cameron had better start jogging. They may also wish to quicken their paces, after the crushing defeat by UKIP in the Rochester and Strood by-election. As a consequence of this defeat, Sterling is now in the cross-hairs of the currency speculators[xxxii]. The first leg down in the currency was all about US Dollar strength; now the downside is all about the weakening domestic Sterling economic and political drivers of the currency pair.
“BRICA – BRAC.”
At the APEC meeting preceding G20, China demonstrated its intentions and capabilities to challenge America and the reserve status of the US Dollar. In an insidious move, straight from Sun Tzu, China metaphorically completed the colonisation of the G20 host nation right under the nose of the former colonial oppressor. The Abbott administration was elected as a proxy for Australia’s resource industry interests; it therefore had no option other than to surrender to China. Last week at G20, Australia signalled that it had become the new letter A, to add to the BRIC nomenclature.
In a ground-breaking deal, which sets the precedent for other resource rich nations, up to 95% of Australian goods, agriculture and commodities exported to China will be tariff free[xxxiii]. This will allegedly boost the Australian economy. Unfortunately, China’s growth rate is slowing and the vast majority of Australians are not employed in the capital intensive extractive industries; neither are they sheep farmers.
China also took another step towards the full convertibility of the Yuan; by opening the Shanghai – Hong Kong stock exchange link and removing the cap on Hong Kong investors’ holdings of Shanghai listed stocks. The PBOC also issued guidelines[xxxiv] on the offshore Yuan holdings allowed for domestic Chinese institutions going forward. Having opened up the door to capital flight from China, policy makers then counterbalanced this move by stimulating the domestic economy with the first interest rate cute since 2012[xxxv]. Hot money however, which plays the interest rate differential game, will just take this interest rate move as the trigger to move capital out of China; enhanced by the easier logistic hurdles that the recent capital market liberalization moves have just created.
“It’s Just Not Cricket Old Boy.”
Presumably, the Australians will soon be getting paid in Yuan for all their hard work. What they then do with it will be more interesting. If they dump it for US Dollars, rather than recycle it back into Chinese goods, services and assets there will be trouble on the horizon for China’s reserve currency status ambitions.
“Ashes to Ashes.”
It should also be born in mind, that political leaders who decide to price their crude oil in anything other than US Dollars have a nasty habit of being thrown out of office very soon afterwards.
“Licence to Kill Mongrels Not Possums.”[xxxvi]
Age of Wisdom, Age of Foolishness (42) “Level 3”
One suspects that another Constitutional Crisis, similar to the one that replaced Gough Whitlam, may soon occur after Australia’s stealth G20 “Aussiexit” from the Commonwealth. It is easy to imagine what Clive Palmer, the politician who refers to the Chinese as “mongrels”[xxxvii], thinks about all this. Any future crisis will no doubt find his prints on the smoking gun that does for Abbott.
“It’s a wonderful life.”
President Obama sent his Christmas list to Congress last week; politely asking for a mandate and a time limit for “boots on the ground” against ISIS[xxxviii].
Consumer’s wishing for lower energy prices for Christmas got an early gift from American lawmakers last week. The lawmakers have decided to go after the commodity franchises of Wall Street[xxxix], which has traditionally squeezed oil prices higher by holding physical supplies off the markets in huge warehouses. It will be interesting to see if the lawmakers have the enthusiasm to go all the way, as has been done with the Libor Rigging scandal. In consequence the leveraged bid for commodities from Wall Street is now evaporating, which will exert further downward pressure on energy prices. The bursting US Shale bubble, audible in Age of Wisdom, Age of Foolishness (54) “Taper Tantrum Redux” just started to hiss a little louder.
“Look What the Headwind Just Blew In.”
Christmas also came early for residents of New York State last week; although not the way they would have preferred.