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posted on 11 March 2015

Epoch of Belief, Epoch of Incredulity (7): Compromising Positions

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Greek attempts to compromise the united opposition of the Eurozone nations spectacularly backfired, forcing Finance Minister Varoufakis to play his final card. This card involved requesting a bridging loan in order to meet the country's current liabilities.

When this request was politely declined by Eurogroup President Dijsselbloem - [i], Prime Minister Tsipras was left with no alternative other than to go down swinging; by making the demands which he had originally made during the elections.

Greece has thus come full circle, all the way back to demanding debt write offs - [ii]. The "Grexit" therefore now exists in principle. The Prime Minister's rhetoric must be customized to a partisan Greek audience, from now on, in order for him to remain at the helm as the ship of state goes down.

To burnish his laurels, Prime Minister Tsipras dipped back into the inflammatory can or worms in relation to German war reparations. His intended audience this time was however strictly Greek and partisan.

Standard and Poor's, which has moved with great alacrity since its punishment for inertia during the Credit Crunch, then swiftly downgraded Greece to one notch above default status. - [iii]

Epoch of Belief, Epoch of Incredulity (6) "Game For A Laugh" reported that Greeks had started to hide hard currency in the mattress - [iv], for that rainy day when the currency black market returns after the "Grexit". Last week, Britain's Royal Mint reported that the Greeks were also buying physical gold coins and bars - [v].

America tried to use what little influence it has left in the German controlled Eurozone. In order to urge a compromise with Greece[vi]. Britain hedged its bets and joined the ranks of nations preparing contingencies[vii] for the inevitability of the “Grexit”. David Cameron officially made the “Grexit” Cabinet policy, when he held emergency meetings with the Treasury and Bank of England to go over these contingencies[viii]. Even Alan Greenspan, famed for stating the obvious in a manner which appears original, thought that the odds finally looked certain enough to call the “Grexit”[ix].

As G20 Istanbul approached, further noises were made about the need for globally coordinated monetary easing[x]; and a tempering of the enthusiasm of central bankers to normalize interest rate term structures. As the meeting ended, the consensus developed and then inculcated into markets was that the “Grexit” is bullish; because it will force the rest of Southern Europe to comply with enforced austerity or face oblivion.

It is true that Greece represents little threat, because its bonds are no longer held on Eurozone commercial bank balance sheets as zero risk-weighted assets. Greek bonds are held in large part by the Troika and the ECB, so they will protect their own interests by putting Greece into a painful reform programme in perpetuity post-“Grexit”.

Spain and Italy could still try some blackmail however, because their sovereign bonds are ranked equal to German bunds in the capital markets and are therefore still held as zero risk weighted assets. At present they are happy to follow the German line on alleged economic reform; as long as their national central banks keep buying their sovereign debt.

The German conditions, on the latest QE from the ECB, will soon put this theoretical appetite for Southern European sovereign debt risk into question however. For now, the current political expediency of the day demands that all this risk must be priced the same; especially now that the “Grexit” will enforce renewed fiscal discipline onto Southern Europe.

Epoch of Belief, Epoch of Incredulity (6) Game For A Laugh noted the pressure on the Anglo-Saxon central bankers to appear independent from this political pressure to keep the party flowing with liquidity. Mark Carney was clearly feeling the scrutiny, for his alleged pact with George Osborne to subsidize vote buying with low interest rates[xi], last week when he felt compelled to defend his position.

He opined that there is indeed some nascent wage pressure in the UK economy[xvii].

Prime Minister Abe must now be feeling totally uncompromised, after Jacob Lew signalled that America is seeking a strong Dollar; and does not judge Japan to be a currency manipulator[xiv]. Japan can now go to work on weakening the Yen even further. Abe also has the substantial financial leverage, provided by the groupthink and inertia of Japanese savers and asset managers, to work with.

Japan has become accustomed to deflation; which has caused a liquidity preference which manifests itself as a tolerance for low yields. Japanese savers are therefore willing to hold the mountains of debt, in excess of 200% of GDP, that the government is accruing. Abe has no fear of foreign investor bond vigilantes driving up yields, as Kuroda does his best to destroy the Yen and create inflation. So convinced are domestic investors of Kuroda’s failure to create inflation, that their appetite and tolerance for low yield has been undiminished by the attempts to create it so far.

Even the inflation blip, from the Sales Tax hike, has created a fall in consumption that is now reinforcing the deflationary spiral. Japan is now exporting deflation to its global industrial competitors. Foreign investors are now bailing out of South Korea, as the full force of Japanese deflationary exports is felt by its manufacturing base[xv]. Instead of creating domestic inflation therefore, Japan creates foreign deflation; which it is then forced to deal with as a second round effect once it returns from the global economy back to source.

So far Japan intends to deal with this self-inflicted, foreign deflationary threat by creating more of it; through exporting even more deflation. A powerful negative feedback loop, with ultimate dangerous consequences for Japan and the global economy, is now being created.

Abe was expecting higher domestic inflation, as the adjustment mechanism to QQE from the BOJ; however in reality global deflation increases as the adjustment mechanism occurs outside of Japan. The problem is that this global deflation adjustment mechanism puts Japan back in the same relative and absolute position once global products fall in price and make Japanese products look expensive again. So far Abe hasn’t worked this out; and Jacob Lew has just given him the green light to find it out the hard way; by doing another round of currency depreciation and deflation export/re-import.

In the absence of global inflation, which feeds back into Japan through rising import prices, that can be matched by domestic producers, there is theoretically no limit to how far the Yen can fall; if Japan’s trade partners do not create the same amount of their own currency for every new unit of Yen being created by the BOJ.

Japan is like Greece would love to be.

The recent fall in energy prices, not only gives Japan another deflationary excuse for currency depreciation but, also provides a huge stimulus to its industrial base. Japan Inc. has therefore received a double whammy, of lower currency export competitiveness and a lower input cost stimulus.

As the momentum investors chase Japanese equities higher, the effective cost of equity capital for Japanese companies falls to ridiculously cheap levels. Japan Inc. has therefore been stimulated by cheap oil, cheap Yen, low interest rates and cheap equity capital. Pretty soon, Tokyo will be the Mecca for investment bankers; that it was in the 1980’s, before it all went sadly wrong. The calls for the Nikkei at 30,000 followed by 40,000 will also become run of the mill. No wonder investors in South Korea are bailing. G20 Istanbul had another gift for Kuroda, on top of that provided by Secretary Lew. Kuroda was happy to report, without any adverse reaction from other members, that Japan had not been criticised for QE so far; implying that he saw this as justification for more of the same going forward[xvi].

Presumably, at some stage in the great Yen depreciation, Chinese exports come under threat also. If Chinese and South Korean GDP slows down to that of Japan’s, because they have been undercut by the weak Yen, then suddenly their debt-to-GDP ratios look as terminally threatening as Japan’s. Abenomics should therefore be understood as the overt strategy of forcing China and South Korea into a position of debt-to-GDP parity with Japan.

Last week, China signalled that it has wised up to Japan’s game. The latest inflation numbers suggested deflation[xvii]; and the PBOC was swift to report that deflation is a precedent for further monetary policy stimulus[xviii]. China and Japan are thus locked into mortal combat, between two trade surplus nations with huge fiscal deficits; who both manipulate their currencies and interest rates, in order to preserve their trade surpluses, at the expense of their savers. Each unit of new Japanese currency will thus be used by China (and probably South Korea also) as the basis for the creation of a new unit of Chinese (and South Korean) currency. Speculators, seem to be interested in discounting this dynamic as a stronger US Dollar, however owning Gold in Yen, Yuan and Won terms would also suffice.

China also reported a fall in shadow lending last week[xix]; which speculators believe implies another round of monetary easing is on the way.This fall in shadow lending however, is a double edged sword; because the drop in lending actually signifies an economic headwind of decreasing credit creation on aggregate.

President Xi will have his first official visit to America in September[xx]. China therefore has, between now and then, to get the issues of capital flight and monetary stimulus under control; so that the data it produces leading up to the visit evinces stability and growth. Alternatively, China can cook the books as it has always done in the past when presenting to foreign scrutiny.

The great enabler of the “Currency War in the Pacific” is currently preparing for civil war, as the Presidential election approaches. Epoch of Belief, Epoch of Incredulity (6) Game For A Laugh explained how America intended to go into the next debt crisis from a position of Dollar Strength. It was also explained how Presidential hopeful Rand Paul’s crusade, to audit the Fed, had enforced a premature tightening bias onto the FOMC; as it sought to appear uninfluenced by the Obama Administration and therefore worthy of Congressional respect.

None other than Jon Hilsenrath himself, provided support for this thesis last week; when he reported that the single Fed Republican Jerome Powell has been tasked with interfacing between the Fed and Congress[xxi].Powell immediately identified himself on the record as a Dove; and a believer in the need for the word “patience” in the immediate FOMC statements to come[xxii].

Powell is a former “White Shoe” lawyer and Carlyle Group executive; so he is effectively compromised in the eyes of the most evangelical anti-Wall Street Republicans. Powell is therefore going to struggle to win his party co-voters round; which means that the Fed’s tightening bias and behaviour will have to be even more acute going forward. Powell maybe able to sell Congress, on keeping its hands off the Fed in return for rate hikes however. He will ultimately have no problem in selling them the idea of more QE, when the markets start to feel the negative economic impact of this Congressionally enforced tightening.

The last thing that the Republicans want to be seen as, are the ones who killed the recovery just as they were the ones who created the Credit Crunch in 2008, as they go into the next Presidential election. If they blow this one, they will have another eight years in the political wilderness, which may in effect destroy the party totally. In fairness to Powell, it must be admitted that he has hit the ground running and in apparent good faith. He began his new role of “Congressional Nuncio” by taking the lawmakers on toe to toe[xxiii]. He chose the bizarre setting, of the Catholic University, to declare his intentions and capabilities; presumably in the eyes of God. He opined clearly that Paul’s initiative would “subject monetary policy to undue political pressure and place new limits on the Fed's ability to respond to future crises”.

At separate less-holy venues, the Hawks Richard Fisher and Jeffrey Lacker ably supported Powell’s defence of Fed independence. Richmond Fed President Jeffrey Lacker told an audience of reporters in Raleigh, North Carolina that Paul’s bill “facilitates high-frequency harassment” of the Fed. Dallas Fed President Richard Fisher told Bloomberg Radio “all this is all about is interfering with monetary policy making” by Congress. Both drew attention to the fact that Congress already “audits” the Fed, using the accounting firm Deloitte and Touche[xxiv]. Fisher then went the extra mile and referred to the Congressmen behind the audit bill as “sheep in wolves clothing”[xxv].

Just to show that the Fed’s Hawks and Doves are united Lacker chose to tighten his FOMC stance, by calling for a June rate hike[xxvi]; which thus demonstrates that the Fed is indeed independent. It also demonstrates that, under Congressional pressure, there is a bias towards Hawkish rhetoric and behaviour by the Fed.

'Wethinks America doth protest a little too much.' The louder America opines about the need for compromise in the Eurozone and coordinated economic stimulus at the global level, the more ambivalent it in actual fact becomes; by nature of the tractor beam now pulling it towards the Presidential election.

The Democrats would like to deploy Helicopter Money and the Republicans would like to confront America’s enemies on foreign soil. In order for either and/or both of these eventualities to occur, the rest of the world needs to go into a crisis which causes capital to continue to fly to the perceived safe haven of America. America therefore has the economic strength; and the moral and political high ground from which to intervene globally. It also has visible global headwinds; which will frame public opinion into accepting another global policy imperative from Washington.

As we have noted, Germany has other plans for creating its own safe haven; however this only serves to confirm the fact that the world is indeed headed for trouble. It also confirms that there is a new pole, in this alleged multi-polar world, that is located at the heart of Central Europe. This new pole may ultimately frustrate American intentions to “Pivot” around a new pole in the Pacific.

The level of rising protest from Congress, over global currency manipulation, was also interesting to observe last week. A bipartisan alliance was created, which threatens to retaliate with tariffs against countries judged to be manipulating their currencies[xxvii]. It was noteworthy that Secretary Lew tried to anticipate this move of Congress, by recently opining that neither Japan nor China are currency manipulators. This move will allow American policy makers to take both countries out of the general Congressional debate over currency manipulation, so that both can be strategically played off against each other in the “Currency War in the Pacific”. Given that the US Dollar is now rising, on the back of Fed tightening and Eurozone fracturing, the Pacific waters will be sufficiently murky enough; to prevent any observer from discerning clearly, overt currency manipulation by America’s regional trade partners in any case.

G20, for all its cooperative rhetoric, did however sound one discordant note[xxviii].

This note is the same one, about IMF voting reform, which became the unhappy swansong for Mr Strauss Kahn. G20 signalled displeasure with American inertia in the reform process. Clearly America wants its cake and eat it, in the form of a stronger Dollar and IMF voting status quo, going into the next debt crisis. Whilst considering the case for reform, IMF Managing Director Lagarde is no doubt following the news of Mr. Strauss Kahn’s “aggravated pimping” trial; as a cautionary tale of what happens to those who try and reform IMF voting procedure[xxix].

This note of discordance seems to be playing a signature tune; that signifies the breakdown of the global foreign exchange regimes which have come under stress, initially from the Credit Bubble which led to the Credit Crunch and then from the successful waves of central bank QE which have ensued.

The Riksbank was the latest central bank to chip away, at the fragile existing global financial architecture, by moving interest rates into the negative zone[xxx]. Just as the humble Greek citizen has been exchanging his/her perceived worthless fiat currency for gold, global central banks have been front-running the stampede. Last week the World Gold Council (WGC) reported that national governments did the second highest amount of physical gold buying in the last 50 years[xxxi].

When nation states front run their own citizens, whilst simultaneously printing more of the paper that the citizens are dumping, the situation is one of crisis. It is therefore no surprise that America is pursuing a strong Dollar policy; in light of the fact that nations and individuals perceive no value in fiat currencies any more. Since all fiat currencies are created out of debt, as IOU’s drawn on the taxpayer, the corollary of this thesis is to assume that debt itself is viewed with the same suspicion.

Central banks have however priced the debt, that backs the fiat currencies, with yields which imply that there is no risk at all. Something is very wrong with this picture. The WGC highlighted Russia, Iraq and Kazakhstan as the biggest gold buyers of 2014. One should note that these countries with petrocurrencies are feeling the heat, as the oil reserves which back their fiat currencies slide. Since the bubble in oil prices was created by the bubble in credit, the collapse in credit is reflected by the collapse in the oil price. Short oil in gold terms, therefore fulfils the same discounting mechanism as being short the “Pacific Warzone” currencies in the same pairing with the shiny metal.




























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