posted on 16 April 2015
Over the Easter weekend, at the beginning of last week, the world's two most important central bankers set the forex trend followers scrambling to get long US Dollars again.
It's the start of Q2 and the U.S. dollar is the only game in town. Janet Yellen opined that interest rates "may" rise this year - [i], which provided the initial weak bid signal. This bid was then boosted by PBOC Governor Zhou. He opined that deflation is worrying him - [ii]; and also that the PBOC has plenty of room to ease - [iii].
His room for manoeuvre was documented in Epoch of Belief, Epoch of Incredulity (11) "Beware the Ides of March". The word deflation is central banker code for the phrase "I am going to start easing again and need a good excuse to do so". Foreign investors in China are hitting the bid - [iv], whilst the alleged dumb retail investors are piling into the equity market on the understanding that the final leg of the bull market has just been initiated - [v]. A weak industrial production number from Japan - [vi], on the ensuing Monday, was the third point on the fundamental analysts' trend line under construction. The weak Tankan report that then followed caused the market to come back and test the rising Dollar trend line; until this data was internally digested and ultimately rationalised as a trigger signal for the BOJ to ease further, rather than to give up in the face of the Chinese assault - [vii].
In the new "Currency War in the Pacific", if China eases Japan must follow. The BIS then warned the global banks to prepare for the impact of rising US interest rates, by raising their capital buffers - [viii].This currency war must be put into the broader context of the conflict between America and China; over who will have the greatest influence in the Asian region.
The Congressional standoff with the Obama administration, throughout his two terms, has led to foreign policy inertia. This was highlighted by Larry Summers last week as he tried to embarrass the lawmakers into a counteroffensive against China's AIIB, the equivalent of the World Bank/AsianDB - [ix]. Britain, the EU and Australia have all signed up for it; because they think that it will create economic activity that they can tap into to drag their economies back to life.
Everyone is salivating at the size of China's reserves; and thinking of all the investment and trade that they can produce. All of China's reserves can only get spent in the nations that it has surpluses with; which so happens to be all those who have signed up for the AIIB, with the notable exception of America. These nations have the vague notion that they can begin to recycle China's reserves in order to rebalance the global economy. It is a powerful motivator; if China is acting in good faith.
America has been lulled into a false sense of security by QE; and the relative economic strength that it has created for the domestic economy versus its global peers. This relative strength is now waning, as the threat of rising interest rates and declining exports from the strong Dollar start to drag. Japan - [x] and America - [xi] reiterated their decisions not to sign up for the AIIB last week. Both countries must now come up with a coherent alternative, which is not just the existing World Bank and Asian DB configuration. Asian trade partners are a bit miffed with Japan, for weakening its currency and undermining their industrial bases. They are equally as miffed with America, for strengthening the Dollar and sucking capital away from their economies. The "Dollar-Yen Accord" between America and Japan, which has been in effect since 2013, has therefore not been without a significant political cost that may ultimately have an economic price. America was happy with the deal when the Fed was QE'ing itself, because QE kept a lid on the Dollar's rise. Now that American QE is over however, there is less in the deal for America in strictly economic terms because the Dollar is starting to become a headwind for growth.
What the occidental participants in China's AIIB have not understood so far, is that China wishes to hang onto its foreign currency reserves and force these nations to accept Yuan instead. Rather than rebalance the global trading system, the AIIB is a vehicle through which China intends to float its currency and force through its global reserve status. Secretary Lew basically said as much, when he opined that the Yuan has not yet reached reserve status, in the opinion of the United States - [xii], in relation to the IMF's SDR basket. China's foreign currency reserves will be used to back the Yuan, if and when the eager AIIB signatories realise that they have been had and start dumping the currency. The Yuan is not yet a global fiat currency like the Dollar and Yen, which are backed by their nations' respective debts.
China's trade partners still do not trust Chinese economic governance sufficiently to grant it fiat currency status; so the Yuan must still be backed by something that can be exchanged for global goods and services. The collapse of a debt bubble in China would further undermine its fiat currency ambitions. As it stands now, the central government is gradually assuming nearly all of the nation's government entities debts onto its balance sheet, as a precursor to fiat currency status.
Once the PBOC is then forced into buying these nationalised debts, through the QE process, China will have achieved fiat currency status by nature of having a currency backed by debt. China is betting that it can close the gap in the graph above, entitled "Room to Act", of American and Chinese debt/GDP ratios. This of course assumes that the GDP denominator in China's case remains larger than America's. It also assumes that foreign holders of Yuan debt are happy to play along with this great enabling story.
The global investment bankers will encourage them in this endeavour; but the national security executive in America may have other ideas. The point, at which fiat currency status is achieved however, is the point at which the PBOC's foreign currency reserves become vulnerable to massive capital flight; as they will now be on the table to back the said fiat currency. Currently these reserves lie with the PBOC; and are recycled back to finance the debt-mountains in China's trade partners (i.e. export destinations).
As China's trade partners cut back on their borrowing and consuming habits, they will however become less reliant on this recycling of China's reserves; as they did with Japan in the 1980's and look what happened there. China will then have the opportunity to put its reserves to work doing something other than recycling; and it is at this point that it becomes really vulnerable to capital flight.
All America and Japan have to do therefore, is to show that their own currencies are harder and freely convertible; and that China's currency just gives the holder a stake in its bubble economy. The IMF then put another plot on the rising Dollar chart and gave the attack on the AIIB and the Yuan a little nudge; when it reported that the Dollar's share of world trade had risen to 62.9% at the end of Q4 2014 - [xiii].Watch this space fight fans.
On the anniversary of Japanese QE on April 4th, the world will be looking to see if the BOJ will press on with more of it; or whether it has another alleged ace up its sleeve. One senses that the BOJ has lost the initiative recently, because it rigidly adhered to a two year timetable to create the inflation that has not occurred. BOJ governor Kiuchi has always opined that this dogmatic embrace of QE and its timeline would catch the BOJ out; and he has now been vindicated - [xiv]. He advocates tapering QE and targeting interest rates instead; but at the "zero bound" can this really be practical? Kuroda has hinted that he intends to start buying ETFs and J-REITs - [xv]; so it is logical to expect that the BOJ will go down this route next rather than Kiuchi's.
A hint of the probable route to be taken was given by, the man with the appropriate surname, Kozo Yamamoto. Mr Yamamoto is a leading light in the LDP and also one of the architects of QE. Yamamoto basically doubled up on the ETF/J-REIT and interest rate manipulation bets; suggesting that the BOJ will do either or both on April 30th - [xvi].
Epoch of Belief, Epoch of Incredulity (7) "Compromising Positions" - [xvii] developed the theme that Japan is exporting deflation, via the weakened Yen, with the statement that "Japan is now exporting deflation to its global industrial competitors". This deflation is then inadvertently re-imported by Japan, when the central banks in its trade partners follow suit and weaken their own currencies.
South Korea is the best proxy and model to study this idea. Last week the BOK reported that South Korean inflation is at its lowest level since 1999 - [xviii]; which lends credence to the thesis. Then Bloomberg's Asian commentator William Pesek also opined - [xix] the same thing, under the headline "Japan's Newest Export: Deflation". Two of the same thing is a pattern. To be objective let's assume that Pesek's report came first and in isolation. Two other similar reports are now required to begin the trend. Market perception has already been framed by Bloomberg's inception of this idea.
What the Fed does for an encore is going to be interesting; because further unilateral weakening of the Yen by the BOJ, followed by reciprocation with alacrity from the Asian central banks, is starting to become a headwind for the US economy.
Yellen's reticence, to commit to a more affirmative stance on rate hikes, suggests that contingencies are already being planned. Stanley Fischer began these contingencies, by framing the exit from QE as "normalization". "Ben.com Bernanke" has now hopped on the bandwagon, of defending his legacy and preparing for something unorthodox to come, with his new Blog on the #grassy knoll at Brookings - [xx]. It is hard to find a better commentator or location, to facilitate the intellectual debate which will prepare the way for a new course of unorthodox Fed action that is just like the old course. If the US economy then shows more signs of slowing, during the "normalization" process, this will be debated on his Blog and swiftly countered with more QE or even the Helicopter from the Fed. One wonders what the communication policy at the Fed will be for comments and input to this Blog from Fed governors. The potential exists for the Blog to become an unofficial tool of Fed guidance and communication policy.
A hint of the way that things might develop was provided by Lael Brainard, who opined that young Americans remain economically traumatised by the Credit Crunch - [xxi]. Clearly she feels that QE has not touched them. Janet Yellen then followed up on this touchy-feely theme when she defended the Fed's interest in income inequality. Apparently the Fed remains committed to studying wealth inequality on her watch - [xxii]. These two Fed officials are obviously keen to explore how monetary policy can be used to touch the disenfranchised, who do not own assets and therefore have not been carried along on the tide of QE.
This all sounds as though Helicopter Money focused on such groups, through wealth distribution and permanent increases in the money supply using the tax code as the agency of wealth transfer, remains on Yellen's to do list.
The Europeans then appeared to drive the US Dollar bid further; with a scenario in which the ECB must remain accommodative in order to enable a grand political solution to the political opportunity presented by the Grexit problem.
Beware of Greeks and Europeans for that matter bearing trading signals however. Within the initial Dollar buy signal from Europe there was a strong note of caution to trust it. Epoch of Belief, Epoch of Incredulity (13) "Situation Normalised All ...... Up" suggested that Alexis Tsipras had been given his orders by Angela Merkel; to return to Greece after their meeting and execute. As the week advanced, the details of this list of orders became clear.
The first up for "execution" is allegedly Yanis Varoufakis - [xxiii], whose negotiating style has not endeared him to the civilised European Union officials. Varoufakis is not going to die quietly unfortunately; and may well wreck the delicate compromise that is being engineered. This compromise involves intense scrutiny of Tsipras's new economic reform plan - [xxiv], which includes a crackdown on tax evasion in addition to privatizations.
As always with Greece, the devil is in the details. Off the record, several EU officials have voiced doubts about the Greek plan - [xxv]. As usual the first draft was long on headlines and short on details. The Greeks seem to think that if they have a paragraph, headed with one of the Troika's demands this equates to not only a solution but also the successful execution of said solution.
To live out this fantasy, "reliable" Greek sources then informed that the country was preparing to reintroduce the Drachma, to pay its social welfare obligations and public sector salaries - [xxvi]. The Greek reform plan therefore resembles a misleading investment memorandum. A new revised document was then resubmitted - [xxvii]. The new plan conformed to the Troika guidelines on privatization; however it then countermanded the Troika directives on labour market reform and pension rationalization in the previous draft.
The Greeks basically try and make a concession in return for taking away a previous concession. They seem to be operating under the view that they are still in a strong negotiating position. The latest iteration of the reform plan also signals that Tsipras is keen not to incur the wrath of the pensioners and the workers.
To further complicate matters, Tsipras's economic reform list is in effect speaking on behalf of his coalition partners - [xxviii]; who in practice may have a totally different agenda. There is therefore no rational counterparty within Greece who can guarantee compliance with the Troika's terms.
To try and create the Greek version of rationality, former PM Samaras has now offered to form a coalition with Tsipras to drive through the economic reforms needed in order to avoid the "Grexit" - [xxix]. This move by Samaras signals that the current coalition is already dead and new elections loom. The Troika's best hope is to now get behind the new Tsipras Samaras axis; and hope that it can deliver. The words hope and Greece are traditionally not found in the same sentence. Jeroen Dijsselbloem summed up the positioning of the Troika, when he said that "They deliver more and more proposals that are more and more detailed. On some parts, we will definitely reach an agreement". - [xxx]. The Troika is in it for the duration of any Greek government that briefly occupies the negotiating chair .... and then some.
Greeks of all political affiliations have demonstrated that, over the years, they all seem to share the common pursuit of money however; even if it does mean bending the rules. This is the tool by which the country will therefore be controlled.
To confirm this observation (and also the "useful idiot" eponym used in these commentaries), Tsipras reached out to Putin to see the colour of his money; and thus to harden the attitude of the Troika even further - [xxxi].
The Greek political system is up for sale; and it is just a matter of haggling over the price. In recognition of this fact, German Deputy Finance Minister Roth urged the country to mend its fences with the ECB so that it can continue to live on Draghi's drip-fed life support - [xxxii]. Draghi's lifeline is conditional upon economic reform; hence the circle is closed for the Troika to enforce its demands via the ECB at discounted bailout prices.
Epoch of Belief, Epoch of Incredulity (13) "Situation Normalised All ...... Up" also suggested that Europe was lurching to the right-of-centre, rather than the far-right. Further evidence of this came in French local elections last week, which cemented Sarkozy's UMP as the official opposition - [xxxiii].
Le Pen senior singularly pushed things further right of centre, whilst simultaneously shooting his daughter in the foot, when he repeated his grand faux pas; that the Holocaust is a mere "detail" of history. Post Charlie Hebdo, such inflammatory words are the kiss of death for any French politician. The events in France support the view that the European polity is sleepwalking head-first into a political union of the German kind. In support of this view, Hollande was swift to try and brush off the collateral damage from the election defeats; and unite with Merkel in a single message to Greece to get its act together - [xxxiv].
The big question looming on the horizon is the coming Spanish elections in six to eight months' time; and the political landscape that will emerge there. Folding this political problem into the converging political union will test all the skills of the political elite in Europe. This one is a much bigger risk than Greece. With Draghi buying Spanish bonds, the threat has been concealed in the capital markets; so it falls to the politicians to build on this stable economic backdrop and sell a new government which complies with the convergent European political theme to the Spanish voters. The Spanish have shown themselves to share the pecuniary nature of the Greeks, so in effect they have already sold their democracy out; and should therefore be easier to manage than Greece.
Readers will remember from Epoch of Belief, Epoch of Incredulity (11) "Beware the Ides of March" that Mr Juncker has called for a European army - [xxxv]; and from Epoch of Belief, Epoch of Incredulity (13) "Situation Normalised All ...... Up" that Mario Draghi has called for a "quantum leap" to European political union - [xxxvi]. Trouble at 'mill in Greece is entirely in-keeping with this grand unifying theme to the right-of-centre. The last act, of the "useful idiot" Varoufakis, will therefore be to attempt an assassination (metaphorically speaking) of the Imperial Arch-Duke and Duchess of the Eurozone. Greek comedic allegories about World War II should in fact be about the Balkans before WWI.
Epoch of Belief, Epoch of Incredulity (12) "Joining the Dots" proposed the idea of the emerging dialectic between the Saltwater and Freshwater Schools of economics over the efficacy and utility of QE and its relationship to deflation. The BIS stimulated this debate with its findings - [xxxvii]; that deflation is actually good for robust sustainable economic growth. Sabine Lautenschlaeger signalled that the debate is now in process, when she challenged the track record of QE last week - [xxxviii].
Britain went into full-on election mode, appropriately on April Fools' Day, judging by the way the parties set out their stalls in the televised NOT Debates. There was very little of real global-macro intelligence to report; other than the debate over which party the wild-card SNP will damage the most. Speculators will therefore take a dim view of the uncertainty and sell Sterling just to be on the safe side.
Good Friday was anything but that for the fundamental global macro guys who had been plotting their long US Dollar strategy all week.
The Nonfarm Payrolls number confirmed Yellen's call for caution about the pace of rate increases. The fundamentalists washed out, whilst the techies got short.... the contrarians used this as the entry point to the long Dollar trade in preparation for April 30th.
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