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posted on 12 April 2015

Epoch of Belief, Epoch of Incredulity (13): Situation Normalised, All ****** Up

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Epoch of Belief, Epoch of Incredulity (12) "Join the Dots" recounted the ostracism of Greece, in political and financial terms; that left it facing the "Grexit" on the eve of a crucial meeting between Tsipras and Merkel. Going into the meeting with Merkel, Tsipras appeared to run the white flag of surrender up the mast on the Greek ship of state; with a leaked letter to Merkel informing that his country was basically out of cash and was hers for the taking - [i].

Having originally referred to him as a "Trojan Horse", Merkel intends to ride him back to Greece where he will then unload the German solution from within his wooden façade. Ominously, during the meetings with fellow Socialists in Germany, Tsipras did not give off a vibe that suggests that he has any intentions of complying on his return to Greece - [ii]. He has therefore served to drive a wedge between his country and Social Democrats in Europe, who were prepared to give Greece a chance.

Tsipras insisted on the usual procrastination in relation to German war reparations; which he has done in the past to divert the negotiations away from the main theme of Greece's unpaid debts - [iii]. Merkel didn't rise to the insult and steered the "Trojan Horse" back to the main agenda. He was allegedly given five days to deliver his second attempt at economic reform proposals - [iv].

Just to help his thought process coalesce, the ECB announced that it will not buy any more Greek bonds - [v]; and will also limit the Greek commercial banks' ability to buy and finance Greek T-Bills - [vi]. The option for the Greek central bank to monetize Greek debt and basically print money, using the central bank's account at the ECB, has been terminated.

Given that the Greek banks' deposit base has now been totally denuded, from a bank run by its own citizens, the country is now incapable of creating credit in Euros to any degree that would move the economic needle. The only source of Euro credit is from the Troika; and this comes with strict conditions.

The ostracism of Greece is however not just by design, in order to get a total capitulation to the Troika's terms. Political opinion in Europe, about austerity and the longevity of the European Union, is being framed by the debate with Greece. Epoch of Belief, Epoch of Incredulity (12) "Join the Dots" observed that the other nations within the PIIGS, were distancing themselves from Greece.

Last week, Portugal put some distance between itself and Greece. Anti-Austerity feeling in Portugal is on the run; and there is no equivalent of Syriza on the political landscape - [vii].

In Spain, the Socialists retained their grip on Andalucia; which is remarkable in that the high unemployment there was supposed to be working in Podemos's favour - [viii]. Social Democrats in Germany are now joining the ostracism; and in so doing are shifting to the right in favour of austerity.

France has perhaps the most interesting political dynamic. Sarkozy is back and his party is pushing Le Pen's Front National into second place - [ix]. The Eurozone in general is lurching to the right in political terms; but not far-right only right of centre. This is just about where the European Union political class could hope that it would be under the current circumstances. The crisis has been turned into an opportunity for economic reform, which then opens the way to more political convergence.

Mario Draghi must now be in his pomp. Having taken credit for the European economic recovery, at his last press conference, he then took on a political demeanour and demanded a "quantum leap" - [x] to political union in Europe. This speech initially sounded incongruous, until the full context was revealed in the changing political events in Europe.

Draghi is clearly of the opinion that all of this "quantum leap" can be achieved by QE, negative interest rates and a few good men in Brussels. Success and a modicum of hubris however, seem to have got the better of him. He has dropped his guard and shown his true intentions and capabilities, by agreeing to attend a session of the Italian parliament - [xi]. Such a move is unprecedented and signals the stealth move of the ECB, even further into the political realm that it is expressly forbidden from doing. Draghi has thus shown himself to be an agent for the ultimate objective of achieving European political union at all costs. Far from breaking the Eurozone, the "useful idiots" Tsipras and Varoufakis have driven Europe further towards political union.

Epoch of Belief, Epoch of Incredulity (7) "Compromising Positions" - [xii] discussed the impact of Japan's exporting deflation to its global trade partners. It should be made clear that Japan is not solely responsible for the current global deflationary trend. Japan simply acts as an example of how countries are attempting to deal with a global deflation phenomenon, a situation that is then made worse as other countries react to their latest moves.

This passing of the deflationary parcel, via the foreign exchange markets, is gaining currency of its own as a trading theme. Kuroda signalled that he is getting an itchy trigger finger again last week. He made it clear that the next phase of QE will involve purchases of ETFs and J-REITS rather than overpriced and largely unavailable JGB's - [xiii]. He thus signalled that QE was never about stimulating domestic lending at all; and is in fact all about weakening the Yen and creating inflated asset prices. Presumably, inflated asset prices will then make the Japanese feel wealthy enough to consume; so that the inflation is a second round effect after the asset bubble has inflated further.

Kuroda's next easing move must be placed into the context of the beggar-thy-neighbour easing that is going on globally. BOJ newbie Yutaka Harada opined that hitting the 2% inflation target will now be difficult to achieve over a two year time horizon - [xiv]. Presumably he had already seen the latest CPI figures - [xv] which, were released a day after he spoke and, showed that deflation is creeping back in. This suggests that Japan is now importing back the deflation that it had exported in previous rounds of QE and Yen depreciation. This highlights the BOJ's problem. Every time it eases, Newton's Third Law of Central Banking means that it begets an equal and opposite easing somewhere else in the global economy. Japan initially exports more deflation via the cheap Yen, which is then reimported through a weakening trading partner's currency after its own central bank reacts, by easing to thwart the BOJ. Only the Gold Bugs are happy, since they foresee deliberate currency debasement all round in the long run.

The latest global deflation signal most evident last week, came from the merger of Kraft and Heinz. Lack of pricing power is forcing these oligopolists to create a monopoly; that will give the merged entity pricing power with both customer and supplier, in addition to massive savings via synergies and redundancies. This is a rational response to the threat of deflation. Rather than buyback their own shares, which gives them no pricing power or cost saving, they have decided to exchange the inflated currency of their own shares for each-others. This mega-merger will now trigger a wave of reactive mergers, as competitors follow suit and bulk up.

If all these merged entities can't raise prices and cut input costs sufficiently to move the bottom line, then the force of global deflation must be judged to be overwhelming. The merger wave will also put a bid price valuation floor underneath the equity markets, facing the Fed's overplayed exit strategy; so that equities will remain expensive on traditional valuation metrics.

Some central bankers have realised that the only way to end deflation is by ending the global beggar-thy-neighbour devaluations; although the temptation to take the easy way out through devaluation remains strong. The UK economy is at the heart of this dilemma; because it appears to be undergoing a Neo-Classical recovery, in which lower prices drive rising aggregate demand.

David Miles - [xvi] and Kristin Forbes - [xvii] have embraced the current fascination with the word "normalization"; and both now call the current disinflation a temporary blip that will lead to higher inflation.

Based on the assumption that three of the same thing is a trend, it can now be said that Nemat Shafik has also joined her normalising trend colleagues - [xviii].

Ben Broadbent then added the fourth plot to the trend-line at the end of the week, when he opined that the current deflation is a temporary phenomenon - [xix]. If one factors in the two Hawks McCafferty and Weale, then the trend can be extrapolated even further. As long as "normalization" is not perceived to be a tightening, there may be some market traction in their views.

If the deflation that is driving demand is created by global beggar-thy-neighbour easing however, then perceptions of "normalization" will swiftly become of tightening instead; and the central banks will all be back racing to the bottom again. The latest surge in UK retail sales, based on falling prices, is keeping the MPC up at night - [xx].

The conviction, expressed by these four Bank of England officials, seems rather misplaced when put into the context of the impending election; that could come out with many unpredictable policy configurations. One outcome is however certain; and this is that Britain's debt mountain is too high, so that whoever wins will have to cut public spending further. First terms are all about getting re-elected; so that the real axe falls in the second term. It has all just become a political game of guessing on which sector of the polity the impact of next wave of cuts will be felt the most. In general, it can be assumed that all will take a hit to some degree; and obviously some more than others depending on the final makeup of the new government.

Based on this baseline scenario, of a falling fiscal stimulus, it is difficult to see the deflationary situation reversing, in the short to medium term post-election, as the Bank's Gang of Four normalizers plus two Hawks suggest. Britain's "normalization" then begins to look more like a monetary policy tightening.

The last FOMC statement showed that America is also not averse to jumping on the currency devaluation bandwagon, once the strong US Dollar starts to act as a headwind for the economy. The behaviour of the Fed should be causing more alarm than it currently is. It is becoming abundantly clear that the Fed had no plan for the exit once it first got into QE back in 2009.

The absence of an exit strategy is becoming evident and more dangerous for capital markets and the global economy. Certainty relating to the exit in June has created the economic slowdown, which has become evident in the recent data; and is now preventing the Fed from acting on its exit signal. The Fed has now degenerated into an increasingly dissonant talking shop; which is calling for a more aggressive risk premium to be built into American asset prices and the US Dollar.

Loretta Mester is talking a rate hike in June - [xxi] and Dennis Lockhart is somewhere between June and December - [xxii]. Charles Evans is some-time after 2015. John Williams would just like to start talking about tightening in June - [xxiii]. If the objective is to give an impression of flexibility, to deny those who would close the exit door by betting on higher interest rates that follow more clear guidance, it isn't working. The violence of the market swings is sending all the wrong signals to those who look for signs of stress and erratic market behaviour as cases for concern. The Fed is therefore creating a very bumpy landing for itself and hence the economy by default.

Last week, Stanley Fischer tried to pour oil on the waters; when he introduced the word "normalization" to replace the edited "patience" - [xxiv]. He did have to concede that "normalization" will not be smooth. In other words there will be no "normalization" per se; and the Fed will continue to extemporize in terms of guidance; and shoot from the hip in terms of tightening. Fischer's speech was also notable, for the fact that it contained a robust justification and defence of QE; and hence the Fed's independence by default. He opined that QE averted the Great Depression.

It is clear that the word "normalization" is also part of the concession to those in Congress who would like to extend their oversight of the Fed. Rather than tighten to signal independence and accountability to Congress, the Fed will "normalize" instead. "Normalization" is therefore an attempt to frame the exit from QE as something more positive than a tightening of monetary policy. Ultimately, it will all be about perceptions of these semantics; so the Fed must do its best to frame the debate.

Fischer signalled that he is of the opinion that the Fed must retain the mandate to use QE as part of its own growth mandate. This implies that if the perceptions become a negative reality again, as they did in 2008, that the Fed will step back in with more QE. Those commentators who follow the BIS thought process would beg to differ with Fischer.

James Bullard has been noted, in these commentaries, as an individual who blows with the FOMC wind. It was therefore no surprise to see him urging for a June rate increase, with the qualification that this will not be a tightening - [xxv]. The Fed is overplaying its hand at trying to exit the QE juggernaut without damaging all the good work that it has done to asset prices and economic activity since 2009. Judging by the saw-tooth sideways behaviour of the markets, this strategy is working; but the daily tactical trading volatility is making some observers doubt that it is.

Once "normalization" is over, growth will have stalled sufficiently to start talking about more QE or even the Helicopter. Those who buy the equity market dips are playing this game, knowingly or otherwise.

Epoch of Belief, Epoch of Incredulity (12) "Joining the Dots" observed the BIS trying to promote its findings - [xxvi]; that deflation is in fact associated with periods of the most sustainable and extended growth.

It was suggested that a major argument between the Saltwater and Freshwater Schools of economics, over the utility of inflationary versus deflationary monetary policy, was about to break out. Americans are clearly not using the windfall gains from falling gasoline prices for consumption - [xxvii]. American deflation has not translated into economic growth. The Saltwater School would use this as evidence for the extension of QE; in the perpetuity known as the Helicopter Money. Jens Weidmann would argue the contrary position; that European consumer confidence is recovering - [xxviii] precisely because the prices of goods and services are falling. Mario Draghi would say that Europe is recovering thanks to him and his "Salty" QE.

Epoch of Belief, Epoch of Incredulity (12) "Joining the Dots" suggested that the UK is set to be the case study of which dogma will win the day. Last week, the ONS released data which showed that the UK economy is on the brink of deflation. If Weidmann's thesis is correct, falling prices will trigger the demand that will support an economic recovery. If he is wrong, then the Bank of England will follow on with more QE of its own. The last FOMC meeting announcement seems to have been the catalyst for this ideological war; as the foreign exchange market has now woken up to the fact that the strong US Dollar is no longer a one way bet. The argument and the volatility look set to become more heated, all the way from now past the UK General Election until Jackson Hole in August.

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