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posted on 20 March 2015

Epoch of Belief, Epoch of Incredulity (9): Comfort Zones

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Global growth suddenly hit the brakes in February this year. Presumably the FOMC is fully aware of this; which is why the last minutes were so full of caution despite all the bravado in relation to a June rate increase. The view taken in Epoch of Belief, Epoch of Incredulity (8) "Hedgehogging One's Bets" was that this bravado is a function of the threat to the Fed's independence from Rand Paul's proposed audit.

The monolithic figures, of the retiring Richard Fisher and Charles Plosser, stand as signals that the Fed must adopt a tightening bias despite its better judgement; because it must appear to be independent of the Obama administration. In its zeal, Congress is therefore triggering another equity market collapse and economic crisis; just as it did in 2008 when it initially refused to engage in the economic bailout when the housing bubble popped.

Last week, Goldman announced that the global economy is officially back in the contraction zone - [i].

So where does that leave us?

The US banks certainly appear to have already taken this view; because they continue to hoard cash in low yielding, high quality and highly liquid fixed income securities - [ii]. The banks can clearly see the economic chaos to come, beyond the event horizon of the first Fed tightening. To underline this deteriorating credit picture, the National Mortgage Risk Index (NMRI) continued to decline last week, for the fifth consecutive month - [iii].

The Fed's caution, in the last FOMC statement, may also reflect the fact that its own recent reporting on industrial production indicates that domestic manufacturers and miners have become pessimistic about growth opportunities this year - [iv]. A consequence of this industrial slowdown was also evident in the alarming statistic, that Apple's stock is now driving the performance of the majority of American equity fund managers - [v]. The lack of growth opportunities in general, has led to the concentration of risk in the only growth story in American industry.

Epoch of Belief, Epoch of Incredulity (8) "Hedgehogging One's Bets" also suggested that Richard Fisher will leave his mark, on the Federal Reserve Banking System, by eviscerating the New York Fed. It was reasoned that this is a rational step to take; because the Fed needs to cut its close links with Wall Street, in order to rebut the criticism and attack from Congress.

Smelling blood on the street, more precisely on Liberty Street, the Independent Community Bankers of America (ICBA) stepped up their lobbying attempts; to have the New York Fed's FOMC vote given to them and used in rotation by each ICBA member - [vi]. The Fed's caution and political dilemma was evident in the way that Yellen chose to play the lawmakers during her testimony and Q&A's last week - [vii]. Whilst championing the cause of independence, she took great care to tag this independence with flexibility to adjust policy; rather than going full on with a recommendation for immediate rate hikes. She therefore prepared policymakers and markets for tightening later this year; but not in June as the Hawks had initially signalled. She also prepared them for a reversal of the tightening at the first sign of weakness.

Despite the Republican Congressmen's direct assertion that Yellen is accountable to the White House, rather than to the American people through the agency of Congress, the cut and thrust of Yellen's Q&A with the lawmakers yielded nothing of true substance - [viii]. In terms of policy guidance, it seemed that Yellen was using her testimony transcript as a verbatim FOMC statement; to be cut and pasted at the next FOMC meeting in March. "Patience" is out and "flexibility" is now in its place.

Perhaps this is because a grand bargain has already been struck, between the Fed and the lawmakers, over the audit the Fed initiative. On the eve of Yellen's testimonies, before both Houses, Richard Shelby the Chairman of the Senate Banking Committee signalled that he embraces Richard Fisher's proposals to change the Fed's voting structure and governance - [ix]. In particular, he is keen to see the power of the New York Fed reduced and redistributed across the regions.

It should be understood that the regions are in fact more aligned with the House of Representatives; hence the Congress will have transferred power from the New York Fed indirectly to itself through the regional banks. A reduction in the New York Fed's power also strengthens the power of the Chairman; and also cuts the embarrassing ties of the FOMC with Wall Street. A deal which reduces the power of the New York Fed is therefore mutually beneficial to both Yellen and the Congress. One can therefore assume that a deal has already been struck along the lines proposed by Richard Fisher.

Rand Paul's utility to redistribute economic power to the lawmakers has therefore served its purpose. No right-minded Republican actually wants political control of the Fed. Neither does Richard Shelby wish to bite the hands, of the bankers, who feed him. A great compromise has therefore been struck that is win-win for the banking industry and the Fed. This deal will concentrate the gatekeeping power in the hands of lawmakers; which makes them attractive as lobby targets for the banking industry, so that it is win-win-win.

Rand Paul may therefore find that he is a useful idiot, who has been used as a tool to create a new form of power sharing deal between the Fed and the lawmakers. With the Fed's balance sheet the size that it is, lawmakers understand that they need to get a piece of this policy action; in a future where their ability to legislate through creating debt is constrained by everything apart from the size of the Fed's balance sheet.

Epoch of Belief, Epoch of Incredulity (8) "Hedgehogging One's Bets" explained how the brakes had been applied to QE by the BOJ, until Prime Minister Abe has safely negotiated upcoming elections. This theme was evident last week; when Etsuro Honda, another one of Abe's advisors, opined that the Yen was at a "comfortable level" - [x]. Abe's reflationist BOJ nominee Yutaka Harada was approved by both the Lower House - [xi] and Upper House - [xii] last week; so progress is being made in transforming the BOJ into a vehicle that Kuroda can drive to Abe's destination of choice. It was also explained how elite groups within Japan Inc. were in on the great transformation trade; involving gearing their balance sheets and operations to a weakening Yen and rising equity market.

A recent survey by Reuters suggests that the great transformation is still in its infancy, despite the Yen already having fallen by twenty percent, based on the fact that the majority of Japan Inc. surveyed was of the opinion that there is no need for more QE and currency debasement - [xiii]. Presumably the more inert members of this cohort, who have not been tipped off yet about the transformation trade, will be the industrial dinosaurs who become extinct. They do however represent the statistic which shows why Abe and Kuroda must ease off the gas, until the elections have been safely passed through. The majority of people in Japan are still not in on the transformation trade, but they still have the right to vote; and so care must be taken when dealing with them.

Kuroda may be easing off the gas in the short term pre-elections, but he made it clear that he has initiated the countdown for more monetary stimulus. Addressing lawmakers, he used the metaphor of a spaceship's escape velocity; to signal that more stimulus is still needed to break out of deflation and head for Planet 2% Inflation - [xiv]. He then started the ignition sequence, when he opined that there is no ceiling on the size of the BOJ's balance sheet - [xv].

In Epoch of Belief, Epoch of Insecurity (7) "Compromising Suggestions" it was suggested that:

"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."

Kuroda is now on the verge of testing this hypothesis.

The amusing distraction, provided by the two "Greek Shirts", finally ended with Greece being given a four month stay of ejection from the Eurozone - [xvi]. It was interesting to see that Spain was even harsher than Germany, in enforcing the strict bailout rule compliance in the debt extension terms - [xvii]. The success of Syriza has created some traction for Podemos in Spain; therefore it comes as no surprise to see the Spanish finance minister sticking the sword into the prostrate "Shirts".

French Finance Minister Macron is also feeling the heat, that Syriza has created within his own Socialist party. In order to force through austerity, he now intends to bypass his own party mechanism; and force austerity issues through parliament by vote - [xviii]. French austerity will now rely upon cross-party consensus. It would seem that France is therefore headed down the same road to coalition politics as the Perfidious Albion. Having been elected on the populist platform of anti-Austerity, the "Shirts" now have no platform left; so in theory they have no further political mandate and will soon be removed from office.

Germany adopted a far more stealthy approach to the ritual slaughter. Not wishing to have blood on its hands, Germany is happy to play the good European and hide behind the more enthusiastic members of the mob who wish to lynch the Greeks.

In fact Angela Merkel sought the Pope's absolution, for the bloody Inquisition that she has unleashed on the Catholic nations of Southern Europe, last week - [xix].

In order to prevent the immediate implosion of Greece, when Tsipras and Varoufakis return to their countrymen empty handed, Germany has sought to rehabilitate them with a new mission. The implosion unfortunately began prematurely, with riots in the capital, before the two failed negotiators had safely returned - [xx]. This new mission has aligned interest with Germany; and may also provide enough fanfare for Tsipras to hide behind in order to hold onto his position.

In the compromise deal, Greece was given the opportunity to come up with some home-inspired reform ideas, before the Troika enforces its own on the nation - [xxi]. Tsipras and Varoufakis have therefore been given the semblance of some form of autonomy and political authority, even though it is totally contrived. The initial reactions to their austerity to-do list, evinced the feeling of scepticism that neither they or the measures they suggest will survive the next four months.

For the IMF part of the Troika, Christine Lagarde wrote to the Eurogroup's head Finance Minister Dijsselbloem; informing him that this list was "comprehensive" but not specific - [xxii]. Dijsselbloem was then prompted by this letter from Lagarde, to announce that it was premature to grant the Greeks a precautionary credit line - [xxiii]. The Troika is waiting to see a detailed action plan; and also to see if Tsipras and Varoufakis survive long enough to implement it.

The Greek government will now Crusade against tax dodgers and oligarchs, as its first self-imposed act of reform - [xxiv]. This should meet with the approval of the average Greek. A reign of Terror will therefore ensue in Greece; during which some genuine criminals will go the Bastille along with many convenient political scapegoats. The Greek names on the "Swiss List" at HSBC Geneva Private Bank will presumably be the first to go; as the proceeds of the original bailout are found to have been transferred to their accounts.

The convenient political scapegoats will no doubt come from opposition parties to Syriza. Given that Tsipras and Varoufakis have been defeated by the Troika, they have their backs to the wall; and therefore will be very vociferous in prosecuting those who represent political threats to them. Given the Greek traditions of melodrama and revenge, the Terror has the potential to become very nasty. It may require military intervention to restore order; which one suspects that the EU has already factored in. Marching into Greece as liberators plays a lot better than marching in as debt collectors. The problem for Tsipras and Varoufakis will come, once they have shaken down the fat cats and still are short of funds to pay down debts.

They will then have to go after the majority of Greeks, who are now hiding cash and gold from the tax authorities and cheating on their tax returns. At this point, they will presumably lose their political mandate; but at least they will have achieved something from a German perspective.

In spite of the "Shirts" attempts to wreak havoc, the Eurozone is however returning to its comfort zone in terms of credit creation and consumer confidence - [xxv].

This may have more to do with perceptions of the ability of ECB QE to solve everything, rather than any innate belief in real growth prospects. It must be said that the signs are encouraging; and suggest that the Eurozone hit the bottom, of an economic triple dip from 2009 and then 2011, in 2014. Collapsing sovereign bond spreads signal that convergence on this comfort zone, in terms of credit risk, is also being currently discounted - [xxvi].

Epoch of Belief, Epoch of Incredulity (8) "Hedgehogging One's Bets" suggested that the divisions within the Bank of England's MPC identified in Age of Wisdom, Age of Foolishness (59) "Patience is a Virtue" - [xxvii] were now becoming impossible for Mark Carney to manage. This proved to be the case last week - [xxviii], when various MPC members used their go-to journalists of choice to leak their views on interest rate policy - [xxix]. Weale - [x] and McCafferty are known Hawks, therefore it was interesting to see Kristin Forbes wavering - [xxxi]. Although admitting that the current position is appropriate, because of falling energy prices, she was quick to point out the threat of financial bubbles that this is creating. The fact that the FTSE hit an all-time high simultaneously, underlined the problem that Forbes highlighted. One suspects that Forbes was hinting more about the sustainability of the "Buy-to-Let" housing bubble that George Osborne and Mark Carney have been inflating.

There has always been a suspicion of a pact between the two, not to raise interest rates until post- election. Osborne's refusal to grant the Bank of England the powers to curb runaway mortgage lending; suggests that he is abusing this position in order to create economic momentum of any form running into the election - [xxxii]. The housing market, as the only true interest rate sensitive sector of the economy which Osborne can influence, has therefore been the only game in town. With no mortgage regulatory powers and little hope of getting them, as the political debate switches to the lack of house building in the UK, the only housing market tool that the Bank of England has is interest rate policy.

Forbes clearly sees the need for a substantial rise in interest rates, in order to deflate the housing bubble that the banks are in no shape to handle. The fact that the big clearing banks still remain in Government custody, suggests that they are now being using as fiscal and monetary policy tools to get the housing market moving. The clearing banks are therefore political vehicles rather than commercial ventures; so any dividends and share sales should be viewed as diversionary theatre to disguise their true political mandates.

Far from weakening as expected, going into the alleged political risk of the General Election, Sterling is getting a strong bid. There is in fact political certainty; because there is certainty in a hung parliament outcome. There will therefore be no outright policy mandate for any party; and furthermore all will have to adhere to strict austerity guidelines, since the debt situation is perilous. Nascent wage inflation dictates tighter monetary policy; therefore the mix of fiscal and monetary policy is supportive of Sterling.

Given the well-publicised shortcomings of the Chinese economy of late, it is no surprise to find that Americans have dialled back their perceptions of the Chinese economic threat. China has been downgraded from a "critical" to an "important" economic threat - [xxxiii]. Mindful of this slippage, Premier Li has therefore signalled that another round of fiscal stimulus is coming; and the PBOC's latest report has signalled that another round of monetary stimulus is needed - [xxxiv].

Price action in the Crude Oil market has got everyone looking for reasons to explain why it is going down again. Roman Abramovich knows why. He recently monopolised a patent for environmentally friendly Fracking technology; that is without water, polluting chemicals and earthquakes - [xxxv]. This game changing technology will therefore elongate the decline curve of American Shale wells, well beyond their expected 2020 death point. It will also cut production costs, so that what are currently assumed to be uneconomic American Shale wells at below $50 per barrel will become viable again; thus increasing supply and driving Crude prices lower.

The Shale producers have no alternative, other than to keep pumping, because they are massively in debt and therefore must meet interest payments on time. Abramovich has a business empire which has taken a hit with the collapse in oil prices and the Russian economy, so he finds himself a victim of the same circumstances. This investment is unlikely to endear him to President Putin; so it must be seen as a calculated gamble. His chances of a getting a Green Card in America - [xxxvi] or a life peerage in Britain have been significantly enhanced; since current American and emerging British hydrocarbon energy security revolve around Shale rather than "boots on the ground".

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