posted on 02 April 2015
Epoch of Belief, Epoch of Incredulity (10) "Flogging the Dead Horse" observed that the threat of Vladimir Putin had brought France and Germany together. This fraternal feeling was underlined at the EU level last week, when Jean-Claude Juncker called for the creation of a European army; for the purpose of being taken seriously on the global stage - [i]. It seems that the Greeks will dodge the draft and any future conflict as usual, since their economic reform proposals were flatly rejected by their creditors - [ii].
Epoch of Belief, Epoch of Incredulity (10) "Flogging the Dead Horse" also suggested that Varoufakis and Tsipras would struggle to hold onto their jobs, after their defeat by the Troika. In order to cling on to power, it seems that they have chosen to adopt the Ledru-Rollin style of leadership. Greece will now allegedly hold a referendum on acceptance of the bailout terms; which is basically a referendum on the "Grexit" - [iii].As Ledru-Rollin said, "there go the people and I must follow them for I am their leader". According to its bellicose defence minister Panos Kammenos, if Greece is not provided with the "dignity" that it has asked for from its creditors, it will then start issuing Schengen visas to waves of migrants (including Jihadists); who will then be given free passage to EU destinations of their choice - [iv]. The "dignity" demanded comes at a price that appears to be the cancellation of $200 billion worth of debts that the dignified country cannot pay back. The first wave of migrants seeking asylum will undoubtedly be Greek therefore using the window of opportunity whilst the country remains in the Eurozone to get out before it is forced to exit.
In the face of such perverse and threatening behaviour, it is not surprising that Germany has signalled that it's time for the "Grexit". Former Transport Minister Peter Ramsauer suggested that it was time for the "Grexit"; and also that this view is held by Wolfgang Schaeuble - [v]. EU finance ministers - [vi] and also Mario Draghi - [vii] offered the final carrot; by pleading with the Greeks to open up their national accounts to closer scrutiny in order to do a deal and administer economic reforms. Greece now faces a clear ultimatum; surrender or die. Faced with this binary outcome, the Greeks are playing their own binary game of good cop/bad cop.
Yanis Varoufakis is the bad cop. He played this role again last week by lodging and official complaint about the behaviour of Wolfgang Schaeuble; and by continuing to play the bad taste WWII card demanding reparations - [viii].
Good cop Tsipras, on the other hand, promises to make all this kerfuffle go away, in return for some understanding and watered down bailout conditions from the Troika - [ix]. Tsipras's attempt at extortion, is perhaps more insidious than the threat of his coalition partner Kammenos to flood Europe with Jihadists on Schengen visas. Greece is still making the fundamental mistake of believing that it is in control of the situation. Following Peter Ramsauer's nudge, the full German "nudge team" of politicians is now nudging Greece to the exit door - [x]. Allegedly, the German euphemism for Greece is a "gangrenous leg" that must be amputated.
Greece can therefore reprise the historical role of Serbia in the Balkans; as it breaks away from the European Empire and precipitates a repeat of 1914. Greece will not go quietly, as Varoufakis and Kammenos have clearly signalled. NATO commanders should be taking the terrorism threat very seriously; and focusing on Greek anarchists with access to fissile materials from Russia, rather than the traditional Islamic threat. Henry Kissinger certainly takes this scenario seriously enough, to warn Russia and NATO to look seriously at diplomatic solutions before embarking on the kind of timetable of escalation that leads to war again - [xi]. What Kissinger understands and Juncker does not, is that Russian foreign policy has always been predicated on prevention of expansion of any foreign power into Eurasia. EU and NATO expansion is such a threat. What Juncker sees as Russian expansion into Ukraine, is therefore seen as EU/NATO expansion into Russia by Putin.
In classic WWI style, both sides misread the other and follow steps which lead to a general escalation of violence. The likes of Varoufakis and Kammenos now have licence to exploit this situation to the full.
The knives have been out for Mario Draghi ever since Age of Wisdom, Age of Foolishness (53) "Lame Ducks" - [xii]. It seems that the ides of March will not in fact do for him this year after all. Draghi has survived to deliver on his timetable of QE bond-buying - [xiii]; that has now moved the term structure of the German benchmark yield curve into negative interest rates out to 2021 - [xiv].His justification is based solely on the current deflationary scenario that Weidmann insists is transitory - [xv].
Draghi, on the contrary, insists that the deflation is systemic and that QE will cure it - [xvi]. Having taken the credit for boosting Eurozone credit, at his last press conference, Draghi now intends to inflate his stature further by creating Eurozone inflation. Benoit Coeure is a little more circumspect than Draghi. Last week he opined that the fall in oil prices and the new round of ECB QE, provide a window of opportunity for economic reforms and also capital investment for growth - [xvii]. Coeure fears that more QE and low oil prices will make Eurozone politicians and CEO's even more complacent in the belief that they do not have to do anything in order to enjoy the benefits of economic tailwinds. The behaviour of the Eurozone to date supports his prognosis. Many observers, most of them German, are opining pride before a fall for Draghi. Ewald Nowotny signalled that one indicator, that should be used to gauge the success of the next QE, is the sign of the term structure of interest rates - [xviii].
When benchmark interest rates in the Eurozone move from their current negative position to a positive one, Nowotny infers that this will signal that desirable inflation has been engineered by QE. Being the consummate Jesuit, which means that he never loses a debate, Draghi is working on a regulatory redundancy; that will prove him right on the positive interest rate vector and hence inflation issue.
Draghi heads the European Systemic Risk Board (ESRB) in addition to the ECB. His rhetoric is steering the ESRB to adopt the dogma and doctrine, that Sovereign Debt is not without risk for capital adequacy standards - [xix].
Currently the European banks with masses of Sovereign Debt on their books, that Draghi would like to buy, are bending the Basel III rules in order to keep the debt classified as zero risk weighted. Once Draghi gets his way with the ESRB, this Basel III rating will no longer apply; so that the banks will have to sell some of this debt and also raise equity capital.
Draghi's detractors opine that QE will fail, because there are no sovereign bonds currently available for purchase since the banks are hoarding them. Such hoarding is also creating the deflation signal that Draghi is using to justify QE. When he changes the rules on risk weighting, the banks will then have to sell; and the ECB will have plenty of bonds to buy. The net result will be a return of normal positive interest rates; and the alleged success of Draghi's QE programme.... QED.
It will be interesting to watch the incandescent rage on Jens Weidmann's face; as he is forced to endure Draghi's smug Oscar winning speeches, at the coming ECB press conferences, when his great scheme becomes clear. The fall in the Euro is already anticipating these moments. Who would wish to own a bond, that one must pay interest to own, in a currency that is falling like a stone. The only rational solution is for a positive interest rate premium to be built, into the term structure of interest rates, in the said currency..... QED. The corollary of Draghi's argument is the very obvious potential for moral hazard; a topic that will be discussed later in relation to similar circumstances in Asia.
Jens Weidmann hasn't used these two little words yet, but one can imagine that he soon will be. Last week he was joined by the Netherland's central bank chief, Klaas Knot; as both warned that further QE was creating a pecuniary disincentive for peripheral Europe and also France to do any form of economic reforms - [xx].In fact, these countries are actually playing Draghi; because by not reforming they are creating the conditions in which Draghi will do more QE. It is going to take a total collapse of the Euro, which then threatens Eurozone asset prices, for Draghi to come to his senses.
The last time that the Euro went into freefall, the BOJ responded with its aggressive QE programme. This time around, Asian central banks appear to be the ones who will respond with alacrity before the BOJ. Epoch of Belief, Epoch of Incredulity (7) "Compromising Positions" - [xxi] observed that Japan was exporting deflation to its neighbours. Mario Draghi has just started exporting more deflation to Asia from the Eurozone.
The problem, for Asian central banks, is the fact that they already have heavily indebted consumer sectors. Monetary easing will help to keep the indebted consumers solvent; but it may also create even more indebtedness.
Asia therefore faces a dilemma, growth or deleveraging; both are however mutually exclusive and mutually compounding of each other - [xxii]. Thailand's central bank provided the first signs that, when push comes to shove, this risk will be taken by opting for more monetary stimulus - [xxiii]. It was rapidly followed by the South Korean Central Bank - [xxiv]. The IMF strongly advised/warned the Indian central bank not to follow suit, because inflation remains a lingering problem - [xxv]. Thus far, Asian central banks have not yet gone down the QE route per se; but once Japan fires up QE again alongside the ECB they are very likely to follow suit.
What we have termed the "Currency War in the Pacific" is escalating nicely into a global conflagration. Richard Fisher's swansong, noted how the US Dollar is the least ugly of an ugly bunch of old nag currencies - [xxvi]. The "Currency War in the Pacific" will only lead to its further perceived beauty.
This beauty could run into the next presidential administration, boosted by rate hikes from the Fed and more growth in unproductive jobs. When this all becomes too much, for the US Economy to handle, the Fed will then have to embark on some competitive devaluation of its own, to remain competitive with its European and Asian partners.
An unintended consequence, of Draghi's next phase of QE, looks set to be the expanding credit bubble in China. Chinese companies are now availing themselves of the funding status of the Euro on an unprecedented scale - [xxvii]. The ECB is thus doing more for monetary expansion in China than the PBOC itself.
To underline the dubious provenance of Chinese debt, the policy makers signalled that they will allow junk status local authorities to reinvent themselves as municipal bond issuers; in order to borrow at significantly lower yields - [xxviii]. This policy is basically creating a "Subprime Crisis" by decree; as local authorities change their names in order gain access to capital that they have been precluded from obtaining thus far.
The spectre of moral hazard is now starting to be discussed by observers of China's capital markets - [xxix]. Consensus is forming, that ultimately the national government will assume responsibility for all this debt; which it will then order the PBOC to monetise.
Thus far the PBOC has avoided this trap with great skill; but all this means is that it ultimately becomes the only buyer of last resort by default. Chinese asset prices are now a function of European QE and creative domestic accounting practices. When these sources of support have been exhausted, it is believed that the PBOC will then be called upon to use its balance sheet in the same way that the Fed has done.
This was confirmed last week, when it was reported that Japanese companies have cut investment, in the nine months through December, whilst cash on hand soared and profits are forecast to hit new highs - [xxxi]. Capital spending also dropped 0.1 percent from October to December, the third straight quarter of declines. During the same period, cash on hand at Japanese companies listed on the Nikkei 225 has risen to approximately 168 trillion Yen ($1.4 trillion); double the level at the end of March 2013, three months after Prime Minister Shinzo Abe took office. Simultaneously, overseas spending has continued to be strong, with net foreign domestic investment down only 5 percent last year from its 2013 peak. Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" suggested that Japan Inc was undergoing a transformation, in order to position itself for secular Yen weakness. This latest data suggests that the transformation is well under way. Data released last week, also showed that Japanese GDP was much weaker than expected in Q4/2015 - [xxxii]. This was explained away as slower consumption from the sales tax hike. The explanation however failed to take into account the impact of the cash hoarding and offshoring of investment plans, which are both consummate with the transformation of Japan Inc. The weak GDP number should therefore be viewed as forensic evidence of this transformation. It will however be framed as the reason for the need for more QE by the BOJ.
One should stop and think about the fact that QE to date has simply increased cash hoarding/offshore investing. QE is therefore creating the symptoms of domestic economic weakness, by exporting investment and deflation abroad, that the BOJ is being asked to counteract with more QE. A powerful negative feedback loop, born out of groupthink, has been created.
The simplistic view, that slow growth requires more QE, is therefore very dangerous; and will lead to a massive policy overshoot by the BOJ with disastrous consequences for Japan's neighbours first and then Japan second. This overshoot will manifest itself in a selling blow-off in the Yen, that will get magnified by the momentum investors and technical analysts who do not understand the fundamentals behind the flows.
Last week, it was reported that China has replaced North Korea as Japan's regional public enemy number one - [xxxiii]. This emerging national security dynamic will no doubt also embolden policy makers in Japan to push Abenomics to the limit; in what we are calling the "Currency War in the Pacific". First however, the BOJ must be goaded into further action; by the next wave of monetary stimulus from the Asian central banks in response to the ECB.
The horse-trading between Congress and the Fed, over "accountability" in return for independence, hit a few speed bumps last week in the form of Fed officials. Following Richard Fisher's initiative to create a compromise, involving the sacrifice of the New York Fed's monetary policy making power, there has been substantial pushback by some of his colleagues. Loretta Mester is the latest Fed Governor to pushback, in addition to the figures of John Williams and Charles Evans - [xxxiv]. This resistance is all the more interesting, because the resisters are both Hawks and Doves.
Janet Yellen made the wise move of reaching out to Richard Shelby last week; even going as far as to be seen anxiously awaiting an audience like any other mere mortal outside his office - [xxxv]. Such disarming humility, is the acme of "accountability" that Shelby's ego desires; and will go a long way to help create a fitting compromise that is win - win for both parties. Yellen needs to move fast however, because her authority (and hence the Fed's "accountability") is being challenged by a probe into the leaking of confidential FOMC discussions on QE back in 2012 - [xxxvi]. This attack has come from the Senate; and is led by Senator Orrin Hatch (R) Richard Shelby's opposite number. In tandem, Federal Reserve Inspector General Mark Bialek is reopening the investigation of this 2012 case - [xxxvii]. This latest scandal to involve the Fed is no coincidence; and is designed for the lawmakers to apply maximum leverage over the Fed's vulnerability.
Under this intense scrutiny, the Fed procrastinated with the release of the bank stress test results; which provided a useful distraction and breathing space, during which the Fed can regroup and mount a more robust defence. The stress test results, by and large, gave the large American banks the thumbs up; with some needing to tweak their capital raising methodologies in order to make the stress test look robust and objective - [xxxviii]. The equity market, celebrated by assuming that dividends from banks can now be paid and raised going forwards.
What the equity bulls overlooked, is that fact that this clean bill of health for the banking system signals that the Fed now has the green light to raise interest rates. The stress test results also signalled another tool that the Fed will deploy, in order to appear to be a tough regulator; and therefore to appear "accountable" by the lawmakers' definition. In addition to being quantitative, bank stress tests will now be qualitative also - [xxxix]; and opine on the risk management, internal controls, corporate governance structure and fit and properness of the executives and board members of the nation's banks.
The Fed is therefore becoming a bank auditor; in addition to systemic regulator and monetary policy maker. It is unlikely that the lawmakers, who now smell blood, will allow the Fed to amass such power for itself without greater oversight and accountability. The Fed is going to lose its opacity and ability to address unforeseen problems with unorthodox (and hence unaccountable) solutions in a timely manner. The next financial crisis is therefore going to be protracted by political interference, until the lawmakers decide to get out of the way.
Mark Carney is clearly worried about the outcome of all this moral hazard in the pipeline. Asset prices rise but there is no genuine economic activity to justify their values.... or to pay the debts on which the asset prizes are financed. He is however unwilling to get off the bandwagon just yet. Accordingly, he therefore chose the city of the Full Monty to opine that there will be no "full monty" along the lines of the Great Depression of the 1930's - [xl]; made legendary by his fellow countryman J K Galbraith and studied in detail by Ben Bernanke. He is however worried that the decline in energy prices becomes rather more permanent than his 2% inflation forecast suggests. Such a permanence would feel like the Great Depression.
The problem for global central bankers is that they have already done as much QE as is humanly possible. The next phase of the game would be to make the temporary boost in the money supply, created by QE, permanent through Helicopter Money. Bernanke left before the Helicopter was deployed; but it was still very much under consideration when he left. Despite what the Fed-watchers are saying about rate hikes, the Helicopter is still very much in the air and could land sooner than expected. The Gold Price doesn't think so; but it is when everyone gives up on Gold that central bankers have the deflation signal required to justify some extraordinary monetary policies.
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