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posted on 26 January 2015

Epoch Of Belief, Epoch Of Incredulity (2) – “Role Reversals”

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Epoch of Belief, Epoch of Incredulity (1) "Beginning the End" suggested a reversal of fortune for the US economy and the US Dollar would get underway in the New Year.

                                             "All Hands Back on Deck."

John Williams provided further support for this worldview last week; when he opined that the Fed should be in no hurry to raise interest rates, because latent economic weakness remains - [i]. Williams is already on record, from Age of Wisdom, Age of Foolishness (50) "Hiding in Plain Sight" - [ii], for signalling that any weakness in the US economy would take future tightening off the table. His recent comments therefore suggest that the tightening is already being taken back. The latest FOMC minutes also signalled that the global headwinds from Europe and Asia were blowing at the last FOMC meeting - [iii], causing the Fed to adopt its "patient" stance that may soon become a reversal. No move on raising interest rates is now expected in Q1. This is the baseline from which to detect any future reversal of course.

The debate over QE from the ECB entered a critical phase last week. The latest Eurozone CPI numbers suggested deflation - [iv]; so in theory Draghi should have the upper hand in the debate over QE. Unemployment in Germany - [v] however hit new lows last week, just as it hit new highs in Italy - [vi], signalling that extreme resistance to QE from Germany will be met with extreme support for QE from Italy. Pundits, including Angela Merkel, have been swift to point out that Greece represents less of a threat of Eurozone breakup risk. This view however omits the new risk posed by Italy. Germany is in a position to argue, with some justification, that its own policies of fiscal discipline are showing tangible economic benefits. Germany therefore in theory serves as a model for how the rest of the Eurozone should behave. In practice, Germany needs higher interest rates, whereas Italy needs lower interest rates and a currency devaluation. Such a clear binary solution therefore begs the question of how the Eurozone can hold together under such divergent trends.

Angela Merkel now appears to subscribe to this binary outcome; and is actively promoting the thesis that Greece can now leave the Eurozone - [vii] with a little wishful thinking thrown in, that this will occur without any contagion spreading. Merkel's posturing should be read as the kind of extreme brinksmanship; in which Germany will threaten the very survival of the Eurozone, in order to extract the economic reforms it demands from each nation as the quid pro quo for QE. Germany has already prepared for the next crisis, by creating a budget surplus. Another debt crisis will therefore have no impact on Germany. In addition, Germany has no budget deficit to monetize and break the rules.

Perhaps the greatest threat to the Eurozone, in fact comes from the political fallout from the "Charlie Hebdo" massacre. Germany has been experiencing a resurgence in anti-Islamic marches of late - [viii]. The French massacres can only have succeeded in increasing the swing to the Far Right in France and the rest of the Eurozone. Since the Far Right parties are anti-EU by default, the political pressure for a breakup has thus increased. The ECB's first action of 2015 was to throw out a potential 500 Billion Euro figure, for the intended QE process - [ix], to see if this scale will assuage the fears in the markets. This is however putting the cart before the horse since, according to Jens Weidmann, QE is legally suspect and by no means a done deal yet. The Eurozone has to stare into the void and address the fears of a breakup first, in order to mobilize the kind of horse trading of QE for economic reform which lies at the heart of the matter.










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