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posted on 15 March 2015

Epoch of Belief, Epoch of Incredulity (8): Hedgehogging One's Bets

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Epoch of Belief, Epoch of Incredulity (7) "Compromising Positions" reported that Japan had received the green light from G20, under heavy American influence, to draw first blood in the "Currency War in the Pacific". Prime Minister Abe swiftly seized upon this initiative; and continued with his project for a return to Japanese militarism - [i], - [i], by attempting constitutional change. Since the ISIS beheadings of Japanese prisoners, Abe has found that there is now a discernible pull from the habitually passive Japanese population; so that he no longer needs to push his militarist agenda as vociferously. Japan has now grown up, after its period of infancy and adolescence in pacifism which followed the total surrender that ended the War in the Pacific.

For those still hoping and wagering that Abenomics will be declared a failure now, rather than be allowed another round of currency weakening, as sanctioned by America and G20, the BOJ has become the critical actor. Governor Kuroda is being scrutinised, with great interest, to see if he has finally given up on ever achieving his 2% inflation target. If he signals renewed commitment to this objective, then it can be assumed that Abenomics still has legs; and therefore the scope to weaken the Yen to levels last seen immediately after World War II.

The Japanese pension fund GPIF certainly still believes in Abenomics and Kuroda's commitment to hitting his inflation target. The institution remains totally unhedged against a strengthening Yen, on both its foreign and domestic portfolios. Given Japan's aging demographic profile, this massive bet is the only way that the technically insolvent pension and welfare system can get out of jail and deliver to its beneficiaries. The alternative is euthanasia.

Japan therefore is in the financial position at which it has no alternative other than to gamble. This gamble has the full faith and support of America, which needs a functioning Japan as its regional proxy in the battle for Pacific supremacy with China. The debate over the wisdom and utility of this unhedged currency position is now being openly conducted in the Japanese media; with Junko Shimizu, a member of the GPIF investment committee, opining that personally he would prefer to be hedged against the Yen strengthening - [ii]. The supporters of Kuroda however outnumbered the dissenters last week; suggesting that a concerted effort is being made to frame public opinion to accept the weakening Yen. Professor Masahiro Kawai, a former advisor to Kuroda, opined that the weakening Yen should not prevent the BOJ from easing further - [iii]. The best signal of Japan's intentions and capabilities came from former vice finance minister for international affairs Takatoshi Kato; who opined that:

"Yields are at unprecedented levels and there's a risk of volatility climbing, but the cost of altering the BOJ's policy framework would be extremely high."

And also that "The market should get used to it." Based on Kato's words, one must assume that there is no turning back on the weakening Yen; because the cost of unwinding this policy would be catastrophic.

Japan Inc. is starting to go all-in on the big falling Yen bet. Japan Post Holdings is finessing it, through buying Australia's Toll Holdings; in what will be the biggest Australian acquisition by a Japanese company to date - [iv]. The Aussie Dollar has fallen precipitously, as China slows down and commodity prices fall. For a Japanese company to buy an Australian company, therefore shows great faith in the worldview that the BOJ is going to weaken the Yen even more than the Aussie Dollar.

Japan Post is the second largest holder of JGB's, which it will now presumably start to liquidate in order to provide the currency for foreign acquisitions.

It also has another trick up its sleeve; in the form of an intended IPO in the near future. The entity is therefore transforming itself, from being a simple repository of JGB's into a foreign investment holding hedge fund. Clearly, if Abe and Kuroda are successful, there will be no creation of shareholder value through owning JGB's any more.

As the Japanese equity market rallies, in line with the fall in the Yen and continued QE support of the BOJ, the cost of equity capital will continue to fall. The current owners of Japan Post will then get the double whammy, of a blowout IPO; and the transfer of all the equity risk, in this huge proprietary trade, to the credulous equity bulls.

It is all very reminiscent of Goldman's "Big Short". Such a gamble, on this corporate transformation strategy, cannot have been made without some serious consultation with Abe and Kuroda; about their intentions and capabilities to weaken the Yen further.

In order not to appear too closely compromised by its connection, to this transformation of Japan Inc., the BOJ signalled that it does not need to accelerate its QE process - [v] at this point in time. There are many in Japan who have been hurt by attempts to create inflation thus far; in addition to the fiscal revenue generating sales tax hike. With elections coming in April, Abe needs to ease off the gas; in order to secure his long-term mandate, to inflate the country out of debt, at the ballot box - [vi].

The BOJ did however confirm that it is still dissatisfied with the current growth and inflation; thus signalling that the process of Yen weakening remains in place for the medium to long-term, once the elections are over. In the short-term therefore, those betting against the Yen must be patient and prepared to take some pain.

Recently published research, by the BIS and Bank of Finland - [vii], conflicts strongly with accepted wisdom on the demographic impacts on inflation in developed nations. The accepted wisdom from James Bullard and former BOJ Governor Shirakawa, which has become doctrinaire, is that aging populations create deflation; because the elderly cohort consume less and saves more. The BIS and Bank of Finland have now challenged this view, with analysis which suggests that the very young and the very old consume more of what they do not produce; and therefore that they are inflationary. Very young and/or very old demographic structures in developed nations are therefore systemically inflation prone.

This new study, by institutions that clearly carry the same DNA of the Austrian School of Economics which is being enthusiastically propagated by the Bundesbank, therefore represents a new challenge to economic orthodoxy. It also represents a new challenge to the current wave of fiscal and monetary stimulus being coordinated at the G20 level. As the global financial architecture is put under greater stress, by more fiscal and monetary stimulus, there is clearly a fork in the road down which the Keynesians and Neoclassical adherents will diverge.

This divergence further increases the risk to the whole economic system; as each camp takes its mutually exclusive view and then waits for the results. Each camp has no intention of coordinating or helping the other; because it is in the interest of each one to see that the other fails.

The hornet's nest, which has been shaken by Rand Paul with his Fed audit bill, fundamentally supports Abe and Kuroda's objective of weakening the Yen. Faced with an audit, the Fed has been forced to err on the side of Hawkish monetary conservatism; which translates into a bias towards tighter monetary policy. This bias is US Dollar positive and therefore Yen negative. The evolving bias was demonstrated to good effect last week, when Loretta Mester became the latest Fed member to insist on the removal of the word "patient"; in addition to some serious editing of the verbose FOMC statements, in order to facilitate a June rate hike - [viii].

Richard Fisher has been a key player in the Fed's counterattack against Congress. His colourful invective has highlighted the populism and dysfunction within the Congress. Americans trust Congress far less than they trust either their President or their central bank.

What the Fed however needs to do, to capture and hold the moral and political high ground, is to visibly weaken its links to Wall Street. The populist notion, which supports the Congress position, is that the Fed took care of Wall Street at the expense of the economy and the American people after the Credit Crunch. The Fed therefore needs to be seen to be punishing Wall Street. Going forward, one can expect to see the Fed's regulation of TBTF and financial conduct of business, to be very repressive of Wall Street interests. Thus, in addition to higher interest rates, the financial sector is going to feel the regulatory headwind blowing cold and hard.

Richard Fisher signalled that the Fed is now heading down "Reform Street", when he openly criticised Bill Dudley's New York Fed. Fisher intends to leave his mark on the Fed, when he retires shortly after ten years' service, by reforming its own dysfunctional structure; in a way that will make it less prone to create the kinds of bubbles experienced during his tenure. Fisher's reforms - [ix] will make the Fed more transparent and also more representative of the domestic economic landscape.

The strong global influence on Fed policy making, via the power of the Wall Street influence at the New York Fed, has created the kind of monetary policy that is deeply destabilising to the US economy. The message from Fisher is, that the Fed is cleaning itself up, thank you very much, without the political interference from Congress. This can only mean that the voting and governance structure of the New York Fed and hence the whole Federal Reserve System is going to be overhauled - before Congress overhauls it.

Wall Street's subversive control of the Fed is going be significantly reduced, in favour of traditional commercial banks from the regions. There will therefore be a bifurcation of the Fed into a global head and regional body; which is better governed and more coordinated as a whole entity.

If the Fed escapes the clutches of Congress, it will morph into the paramount global central bank without peers. The Chairman will still have the ultimate casting vote power at the apex of this two headed beast; however this power will be balanced by both global and domestic inputs and controls. The Chairman will therefore be the most important person in America and the world; however with this greater power will also come greater responsibility. Richard Fisher will thus go down as one of the most important men in American history.

Charles Plosser is also keen to leave his mark before he retires. His last speech epitomised what it means to be a collegiate and cohesive Fed Governor, when the institution is under attack from lawmakers. Plosser opined the need for the dropping of the word "patient"; in order to achieve a June tightening - [x]. He also strongly defended the Fed's independence - [xi]. Plosser is the epitome of the Fed's tightening bias, in the face of political attack, in order to convincingly appear unequivocally independent.

In practice rather than appearance, the Fed is still as equivocal as ever; so that its words have even less value than its ultimate actions. Guidance remains as pointless as ever. This is highlighted by the current equivocation over the alleged June tightening.

The biggest signal, that the Fed has adopted a reluctant bias towards tightness, came from the FOMC minutes themselves - [xii]; which showed that the majority of members were still fearful of the global headwinds buffeting the American economy. Despite all the bravado about tightening in June, the FOMC on the whole remains uneasy. The bravado is therefore based on pressure from Congress; rather than rational decision making based on the perceptions of the economic situation.

Across the vast Pacific theatre of war in Australia, the Reserve Bank is nudging the politicians and the people to confront the fact that the Australian economic way of life has changed fundamentally - [xiii]. The fall in commodity prices is enforcing a fiscal discipline that the politicians do not wish to accept yet; and therefore they will be forced to accept it by adverse capital markets discounting of the problem.

Currently, budgetary income from the resource sector, does not cover the fiscal outlays. Australia is no longer the great Beta play on Chinese growth - because there is no Chinese growth. The vast amount of debt that Australia has accrued, as a result of this fundamentally incorrect one way Chinese bet, must now be worked out; without involving the same kind of default threatened by similar Emerging Market plays such as Brazil.

Governor Stevens therefore cautioned that, whilst the RBA will do its part to alleviate the interest rate cost of all this debt, the public and private sector must tighten their belts. He emphasized that interest rate cuts will be less effective in the next phase of this debt workout; which implies that fiscal austerity must be relied upon to deliver the solution.

The minutes of the RBA's first meeting of the year, which produced the interest rate cut, confirmed that the Chinese slowdown was the key factor influencing the decision - [xiv]. No doubt Japan Inc. has noted the need for Australia to tighten its fiscal belt, which supports the Aussie Dollar; and used this as an entry point to acquire Australian assets.

On the Eurozone front, attempts at mediation and compromise by Jean-Claude Juncker, to bridge the finance gap in Greece in return for pledges on further economic reform were trashed by the Northern EU members rather than by Greece itself - [xv]. There is now total mistrust on all sides, so that Greece is still effectively outside the Eurozone at this point in time.

The damage to the Eurozone has already been done however; as Spain's Podemos is gaining in credibility and electability as a consequence of Syriza's alleged success - [xvi]. Upcoming Spanish elections therefore represent the next political hurdle for the Eurozone. The fault line now extends into Portugal, as the debate over continued austerity has opened up there again - [xvii]. Faced with the growing number of hurdles, momentum in the Eurozone only has ECB QE to sustain it.

Last week, the ECB extended emergency loans to Greece; which had the effect of keeping the negotiations with the Troika alive - [xviii]. Greece then asked for a six month extension to the bailout facility from the Eurogroup - [xix]. The ECB has therefore kept Greece in the Eurozone for another two weeks; in which time the country tries to remain in the Eurozone for another six months.

Germany seemed to take macabre pleasure in rejecting the Greek request for a six month extension, when German negotiators referred to it as a "Trojan Horse". Tsipras and Varoufakis may now be regretting their use of the Nazi metaphors, in their first ill -considered attempt at negotiations. Their position now looks completely untenable. They will either be responsible for Greek adherence to austerity, or for the Grexit that will destroy what remains of the economy. Either outcome is not consistent with their remaining in office.

Their tie-less, two shirted assault on the European Union was an amusing distraction while it lasted. The ECB QE however is being technically undermined by the growing political risk. Risk perceptions translate into a flight to quality, within the Eurozone, as well as away from it. Hoarding, of what are perceived to be safe haven bonds, will therefore frustrate the ECB's purchasing power - [xx]. What will become available, for purchase by the ECB, will be the potential Eurozone exit category securities. The ECB will therefore find itself once again in direct conflict with Germany. Whilst the Germans force the non-austerity compliant sovereign nations onto the Eurozone "exit-list"; Mario Draghi will find that this "exit-list" becomes his only effective QE buying list. To buy from this list however would be to risk insolvency; which will temper his enthusiasm once he understands that his terms of reference for QE have been compromised.

The ECB (and EFSF) is therefore staring insolvency in the face, if it goes ahead with the national central bank buying of sovereign debt, because it will be the entity called upon to fund the purchases of the "exit-list" sovereign debt. This is the point at which the over-gamed game theory, in relation to the Greek endgame, gets gamed out by the Germans.

Varoufakis assumes that the Troika will put up a bridging loan and accept some debt write-downs. From a German perspective, the financial impact of a Greek debt write-down is more expensive than the Grexit itself; since a write-down will then allow other nations to welch on their own debts. The Grexit is therefore the best outcome for Germany, from a pecuniary perspective. Germany may as well force Greece out of the Eurozone asap, since it has less to lose from this outcome; and may actually gain something by frightening other nations into not leaving and abiding by austerity.

Varoufakis does not seem to understand that Germany already started off with the baseline assumption of the Grexit and not a write-down.

Age of Wisdom, Age of Foolishness (59) "Patience is a Virtue" - [xxi] suggested that a division within the Bank of England's MPC (Monetary Policy Committee), over the direction of interest rates, was about to break out; because nascent inflation has become uncomfortable for the more Hawkish members. The suspicion that Mark Carney is in league with George Osborne, to hold off on rate increases until after the election, adds a further dimension to the MPC's problems. The oil price driven collapse in inflation, has allowed the MPC to appear unanimous in maintaining interest rates at current levels.

But the latest meeting once again showed that dissent is breaking out. There were two discordant voices, even though the final vote was unanimous - [xxii]. It is assumed that these voices are McCafferty and Weale's, however Ben Broadbent has recently opined that the fall in inflation will be temporary, which pushes the potential dissenters to three - [xxiii].

There is more forensic evidence that the Chinese Local Government Finance Vehicle (LGFV) system is blowing up. Last week it was reported that there are now 50,000 auditors investigating this sector across the country - [xxiv]. The size of this debt grew to $2.9 Trillion in 2013. By 2014 the bubble had started to deflate. Presumably the auditors have been engaged to find out just how big this bubble is now; and also if it is collapsing through central government curbs or through defaults. It is certain that it can no longer grow, through investor subscriptions, because investors have shunned this sector for some time.

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