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posted on 04 April 2015

Epoch of Belief, Epoch of Incredulity (12): Join the Dots

Written by ,

Last week, observers began to connect the dots in the FOMC announcement and economic projections that supported it.

These dots were pencilled in by Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" - [i]; which explained how global policy makers and central bankers had become uneasy about the lack of growth.

Deutsche Bank has noticed how the last five FOMC projections have continuously lowballed GDP projections - [ii]. Is the FOMC just crap at forecasting, or is it trying to frame market expectations to accept the kind of perpetual stagnation which demands Helicopter Money?

Supporting the thesis that the FOMC is fuelling the Helicopter was another point on the unemployment forecast chart. The Fed keeps moving the goalposts on the natural rate of unemployment (full employment), at which it will have to tighten, lower - [iii]. The new rate has been lowered to 5.2% from 5.5%. The Fed is clearly dodging the issue of tightening.

The Fed chose this latest FOMC announcement to focus on the weakness in the economy that has been evident since Q4/2014. This weakness has been lost in the headlines over the alleged June tightening; and the innate FOMC tightening bias inflicted by Rand Paul's quest to audit the Fed. This tightening has been discounted by the momentum traders in the FX markets, to such a degree that Dollar strength has become a headwind to an economy that is already slowing.

The FOMC decided to deliver on its signals of the removal of the word "patient" - [iv]; but simultaneously rescinded this move by opining the threats from the strong Dollar to an already weakening economy - [v]. It was also a moment for Yellen to use the data and strong Dollar threat headline to launch a counter-offensive against the would-be auditors. The word "patient" was dropped but the word "foolish" was adopted in its place, in reference to the Congressional audit mob - [vi]. Yellen illustrated that the Fed is "accountable" to the economic data, which forms the basis of its independence.

Epoch of Belief, Epoch of Incredulity (11) "Beware the Ides of March" observed that German preparations for the "Grexit" had been initiated by Peter Ramsauer and the German nudge team - [vii]. Political opinion was framed, in order to provide fundamental support for this lead taken by the politicians early last week. A poll published by the ZDF network - [viii], found that 52 percent of Germans now want Greece to leave the Eurozone; up from 41 percent in the previous month.

The perverse behaviour of Yanis Varoufakis and Alexis Tsipras, in relation to German WWII reparations, has no doubt created this German sentiment. Within the survey, it was found that 80 percent of Germans think that the Greek government "isn't behaving seriously toward its European partners". This statistic implies that the majority of Germans still identify themselves with the Eurozone; with the caveat that the other nations must behave "seriously" towards German demands for economic reform. German resolve was further strengthened when Wolfgang Schaeuble opined that time is running out - [ix].

The IMF joined the press gang, by giving the dubious accolade to Greece of being the most unhelpful nation that it has ever dealt with - [x]. The ECB then stuck the boot in, by awarding Greece less emergency funding than it requested at the latest round - [xi]. Going into a meeting with Angela Merkel, Prime Minister Tsipras was therefore in no doubt that there is a united front of opposition to his threatening negotiation style. Mario Draghi even called for a "quantum leap" - [xii] towards Eurozone political integration; which flies in the face of Tsipras's demands for sovereignty and debt write-offs. Jeroen Dijsselbloem, went so far as to advocate the Greece deploys capital controls; which would be the first move to be made after the "Grexit" - [xiii] and no doubt something being advocated by the IMF pre-"Grexit".

The last hope for Tsipras and Greece itself was therefore set up, in the form of Angela Merkel. Whilst Tsipras was talking the "dignity" talk, Merkel was sounding conciliatory by opining that she would try everything possible to help the Greeks - [xiv]. Merkel knows that she has internal limits from the German people and a whole host of other European partners; who have framed the context of her upcoming meeting with Tsipras as her way or the highway.

The convening of European Union ministers, late last week, provided the carrot for Tsipras to chew after the "Grexit" stick had been brandished earlier in the week - [xv]. This carrot contains juicy refinancing in return for adherence to austerity rules in the to-be-announced Greek economic reform list next week.

The "PIIGS" seem to be becoming the "PIIS" as the "Grexit" approaches. Italy became the first member of the group to begin distancing itself from the dead meat. Whilst Varoufakis was hammering Draghi for QE and asking for some other stimulus plan for Europe, Italian Finance Minister Padoan was swift to point out that it is working for his country - [xvi]. Since nobody is buying Greek bonds and everyone is buying Italian bonds, on the assumption that there will be no "Itexit" after the "Grexit", the reason for this divergence of opinion is clear.

The risk however remains, that the "PIIS" use the low interest rates provided by QE as the cushion and buffer to prevent them from applying the economic reforms that Draghi and Germany are calling for. Benoit Coeure has already opined this inertial risk - [xvii]; and it was reiterated last week by Steven Maijoor, the Chairman of the European Securities Markets Association (ESMA), at a National Association of Pension Funds (NAPF) - [xviii] conference.

The Bank of England signalled that it was prepared for the "Grexit", when Alex Brazier the executive director for market stability suggested that this event could trigger a significant market correction - [xix].

Epoch of Belief, Epoch of Incredulity (11) "Beware the Ides of March" suggested that Mario Draghi intends to remove the zero risk weighting of sovereign bonds. It is therefore becoming clear that the concept of credit risk is being incorporated into the sovereign bond investing universe. A failure to adhere to the spirit and wording of economic reform is going to get discounted into sovereign bond yields over time. The slide in the Euro against the Dollar will also focus the attention of holders of European sovereign bonds onto how much yield adequately compensates them for this credit risk as the currency risk escalates.

The falling Euro is no longer the place to discount sovereign credit risk.

Rising US yields should stimulate further investor perspicacity of this sort. Those who don't reform, will pay higher interest rates to borrow; and will also find that the use of their bonds as collateral in the securities lending markets becomes restricted. Most likely the ECB will also set up different collateral pricing limits, related to this credit risk, in order to enforce the new regime; and hence to enforce economic reform onto the countries with low collateral values. Capital will remain constrained, for countries that do not reform; and will become abundant for those that do.

QE will therefore create a pecuniary advantage to reform, rather than remain as a disincentive. Spain certainly seems to have got with the programme. Further adherence to austerity and distancing from Tsipras and Varoufakis has allowed the Podemos risk premium in Spanish government bonds to be reduced - [xx].

The "Currency War in the Pacific" entered a new phase last week; and now threatens to become a global conflagration. Both Britain - [xxi] and the EU - [xxii] took the unilateral steps of signing up to China's alternative to the World Bank last week.

These actions have drawn swift and deafening criticism from America; which views the issue as a national security matter more than just a trade deal. American reaction to the BRICS, when they challenged its hegemony, was to strengthen the US Dollar and drain capital from the challengers. Logic therefore suggests that this will be the reaction again.

More worryingly however is the deterioration in relations between America and Europe, at a time when both should be looking to support each other and economic growth. Christine Lagarde warned the emerging markets to expect the worst as America reacts to this new challenge; when she referred to the next "Taper Tantrum" - [xxiii]. With all this political pressure building for a stronger US Dollar, it is therefore rational for the FOMC to take back the tightening.

The Bank of England is also worried about the headwinds created by a strong currency - [xxiv]. The rise of Sterling against the Euro has been a cause for concern. Britain is in a peculiar state because its recovery is almost neo-Classical; as the consumer recovery is driven by lower prices in the shops - [xxv] rather than employment - [xxvi] and wage growth. The pace of wage growth has been decelerating, at such a pace as to make the MPC Hawks choke on their words for a rate hike - [xxvii]. Chief Economist Andy Haldane now sees the odds of a rate hike or cut at 50:50 - [xxviii].

Britain therefore has an economy that has been geared to deflation and QE. Mark Carney's reluctance to take away the QE stimulus is thus based on a frightening rationale. The UK economy is starting to show signs of a slowdown after Osborne's drive to boost the housing market is wearing off just as the country goes to the polls. Osborne has done a great job, in timing the recovery with the electoral cycle to perfection. His last budget of this parliament gave little away, because the vote buying has already been done - [xxix]. It did however hint that massive fiscal consolidation is on the agenda, in addition to paying for Osborne's early vote buying, for whoever forms the next government.

Based on this prospect, Mark Carney is also in no hurry to tighten monetary policy. George Osborne gave FTSE a boost with his budget for savers; and he will no doubt be taking credit for causing it to break out to become the global equity market leader. FTSE is the place to bet on perpetual economic stagnation begetting perpetual QE. Stagnant input costs and wages hit the bottom line and QE hits the share price. This price action will be rationalised as faith in a return to Neo-Classical economics, which is guaranteed to infuriate the Germans even more than jokes about the 1966 World Cup and two World Wars.

Osborne is now odds on favourite to become PM whenever he wishes to do so. Just to finesse it, Sterling will get the bid back because the alleged Neo-Classical UK economy will appear attractive to the more feckless of the momentum investing crowd. Sterling strength, will then create the kind of economic headwind that creates the deflationary conditions that the alleged Neo-Classical UK economy is supposed to be geared to. Sterling strength in actual fact will just lead to more easy money from the Bank of England; which is the true source of the apparent Neo-Classical recovery.

Sterling strength will, however, attract more flows into the UK, which will then stimulate more economic activity and boost the FTSE even further. When the Bank starts talking about overheating and the need for higher interest rates, Sterling will get even stronger. It all reminds one of the palaver that has been behind the US Dollar's rally to date. Osborne's move from Number 11 to Number 10, is essentially predicated on these smoke and mirrors. He has the hapless figure of Gordon Brown to remind him of what bad timing can do to a Chancellor who waits too long for an economic boom to propel him to Prime Minister status.

The BIS made some interesting prognostications last week; which will have created an unhealthy debate amongst its shareholders. As the global economy embarks on another round of monetary stimulus, led by Asia, the BIS has decided to take the side of its Freshwater economic school shareholders over that of the Saltwater School. Whilst opining on the threat of another risky asset bubble - [xxx], as a consequence of QE, the BIS released the results of a more fundamental study. This analysis would seem to be born out in vivo by "Neo-Classical" Britain. The BIS found that falling prices have been associated with more vigorous and sustainable economic growth throughout history - [xxxi].

This analysis therefore suggests that the current vogue for QE and inflation targeting at the BOJ, Fed, Bank of England and ECB is baseless; and that their leaders are charlatans. One can imagine Jens Weidmann pouring over the details in this report with great enthusiasm. The central bankers' central bank has just provided the evidence for the Bundesbank to launch its next intellectual challenge to the ECB. Currency traders take note!

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