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posted on 20 April 2015

Epoch of Belief, Epoch of Incredulity (15): Squeaky Bum Time

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Central bankers, politicians and English football managers are all experiencing a strong feeling of "Squeaky Bum Time", as the Footie season and global QE run into injury time.

Last week Bloomberg reported that Global reserves declined to $11.6 trillion in March, from a record high of $12.03 trillion in August 2014, ending the five-fold increase that began in 2004 - [i]. Commentators were at a loss to explain this observation. Some said it was a mathematical artefact; as a result of the increase in the value of the Dollar, which has reduced the value of other reserve currency holdings. Others said it was the end of the decade-long accumulation of US Dollars by emerging market central banks. All however admitted that it signalled an uncertain future.

Emerging market central banks facing recession, will find it harder to ease monetary policy in the future. Oil producing nations, now facing a bear market in the currency in addition to the commodity it prices, also face threats to their ability to stimulate economic growth. America may find it hard to expand its fiscal deficit, as foreign holders of US Dollars become constrained buyers of US Treasuries.

What this all seems to signify is that the great wave of US Dollar (and hence credit) creation, that began in 2001 and was boosted again in 2004 and 2009, has reached its apogee. This of course means that those expecting tighter monetary policy from the Federal Reserve, have got it totally wrong. In fact, if history is any guide, we are standing on a new phase of expansion of the US money supply; that will then leak out into the global economy.

The scaremongers then extrapolated the fear trend-line into the Eurozone, with the news that the Euro is losing its reserve currency status. Central Banks cut their Euro holdings from 28% to 22% last year - [ii]. Once again, the decline of the Euro in value gives this reserve statistic an element of artefact; but this does not explain the whole story.

What is happening is that it has become a global funding currency. As long as one can borrow cheaply in Euros, which implies that someone is willing to lend to one in Euros, it will maintain reserve status. Since Mario Draghi is willing to oblige, as the Uber Euro-lender pre and post "Grexit", it would be unwise to write off the Euro just yet. The headlines appear to have been designed to accelerate the Euro's depreciation.

The Gold price has suddenly started to pay attention to all these problems in "Reserve Land"; and the implications for the creation of more credit. The US March Employment Situation report has sent Fed Governors scurrying to revise their tightening timetables. Bill Dudley - [iii] and Jerome Powell now see a shallow trajectory for interest rate hikes, whilst Dennis Lockhart - [iv] sees them beginning in July or September rather than at the June FOMC meeting.

The release of the FOMC minutes last week, showed that the Fed still remains heavily divided over the trajectory of interest rates in the near-term - [v]. Public and market opinion is now being framed into more than just rate hikes. The inception process has just started to move the frame of reference away from interest rates, to the whale in the room that is the Fed's balance sheet.

The big signal will now come in relation to what the Fed will do with the proceeds of its investments, in 2016 - [vi]. If it rolls them over, then the trajectory of interest rates will be smooth and shallow. If it does not roll-over, then the spike in interest rates and volatility will be disastrous for the capital markets and the economy. Epoch of Belief, Epoch of Incredulity (14) "Get Long the Dollar for Good on Friday" observed the Fed embarking on a new phase of monetary expansion by stealth, using the cause of the asset poor who have thus far been disenfranchised from the benefits of QE as the excuse.

Narayana Kocherlakota hitched his wagon and also the cohort of the greater Native American nation to this new monetary pony last week, with the inauguration of a national development centre of Indian reservations - [vii]. To get the venture off to a good start, he also advocated postponing interest rate increases until 2016 - [viii]. North of the border Perry Bellegarde, the leader of the Canadian indigenous peoples, also began to push for greater sharing of the wealth; with the threats of litigation and environmental challenges to natural resource exploitation - [ix].

Clearly also, "Joe-Six-pack" ain't goin' back to the casinos any time soon; and since the reservations where the casinos are located are also located where America's new Shale deposits are, the Federal government can avoid the environmental lobby by playing it off against the native American lobby. Retiring Fed governor Kocherlakota will now become an oil baron.

"Biggish" Oil and Gas gave a further signal of the global deflation in process last week, as Shell snatched up BG; allegedly for its Brazilian assets - [x]. Said Brazilian assets may become encumbered as "Latin American Spring" blows through Brazil; so this is unlikely to be the real reason behind Shell's move. Consolidation in order to be build scale and pricing power, in the face of declining energy prices, looks more likely to be the reason behind the move.

Shell has given up on the oil price recovering any time soon; and is now betting on gas as a lower fruit on the tree as global environmental policy sees green alternatives substituting for the hydrocarbon incumbents. Shell has taken a look at all the wind-farms, solar plants and hybrid vehicles and decided it's time to transition. For Shell, gas is the transition fuel on the step to renewables. Said transition is painful in acquisition cost terms; however since there is ample global liquidity and Shell's share value currency is inflated by this liquidity, the cost of transition is affordable.

This contrasts with Exxon, who is now betting the farm on US Shale oil - [xi]. The energy sector, even more than housing back in the bubble days, represents a fundamental systemic challenge to the global financial system; since it is the ubiquitous and necessary lowest common denominator for all economic activity. Oil at $250/barrel triggered the recession in the developed economies, more than the Fed's premature tightening or even the housing bubble bursting. Now oil at sub-$50/bl is going to cause a problem for the energy and financial sectors, which are still geared to it being at $100+/bl. This time the pendulum has swung in the consumer's favour, as the banks are increasingly at risk to an energy sector in deflation crisis. The energy sector in flux, therefore looks set become the source of another systemic crisis for the banks.

With the likes of AIG out of the game, the big banks have been selling insurance against falling energy prices to the US Shale Companies; often as part of the convoluted loan packages they have used to finance the sectors growth into a bubble. The banks have therefore been lending and selling naked puts on the oil price. The banks probably sold what they thought were far out of the money puts at ridiculous premiums; and have since booked the premiums as profits and paid some tasty bonuses to boot. Now the borrowers can't pay interest and principle on their loans; and in addition are exercising their put options to come up with operating cash. It all sounds just like the housing bubble.

Suddenly with the fall in the oil price, these hedges offer more value in the US Shale companies than their E&P operations - [xii]. In fact the more the oil price falls, the more valuable the P&L in the hedges becomes. US Shale is therefore a huge oil price put option play; and the companies are busily pumping more oil to drive the price down and hence to increase the value of their put options even more. In addition, the banks have been financing a huge carry trade in which the oil glut is stored on ships, rail-cars and bunkers which are now full to the brim. The only place left to store oil is in the ground; which means closing down operations. It will be interesting to see if banks actually finance the production of crude which is then pumped back into the ground because there is no storage above ground.

This may sound absurd, but currently banks are financing Shale companies that are cutting back production; and defining the un-pumped crude as oil reserves on their balance sheets, which is equally absurd. Add to this the latest stampede of native Americans with Big Chief Kocherlakota at their head; and the situation becomes one in which bank risk officers' bums start to articulate with alarming frequencies.

Energy sector fixed income is also an asset class which is giving off some funny noises and smells of its own. The IMF has started to squeak about the bond market again; and the risks compounding there through leverage and the hunt for duration and yield, in its latest Global Financial Stability Report - [xiii].

The banks have apparently dodged this golden bullet however; which has gone through and through, from the clearinghouses and firmly lodged into the asset management industry. Last week, captive Fed governor Tarullo was led on a merry diversion by his captors, into the world of the clearinghouses; where allegedly global systemic risk now resides - [xiv]. Logic and painful experience suggests that the next American bailout cannot involve the banks directly, therefore it must be framed as a risk to the asset managers and clearinghouses; so that an apparently fresh bailout bill can be presented to Congress when the time comes.

Even before then, the Fed will no doubt be busily easing again to avoid the inevitable crash. Faced with this risk, the central bankers are afraid to tighten prematurely; however if they continue with easy money the risk is going to overwhelm them when they ultimately exit QE.

One man with the intestinal fortitude and motive to embrace the coming crisis is Bill Dudley. Dudley and the New York Fed have been living under a question mark, ever since the retiring Dick Fisher suggested that its FOMC vote should be rotated throughout the community and regional banker members of the Federal Reserve System. There is a feeling in Congress and "Main Street", that the Fed has been captured and held prisoner by Wall Street through the agency of the New York Fed. Dudley and his charges therefore need to reinvent themselves and hence their usefulness asap. It seems that Dudley has chosen to come at this from the systemic crisis angle. Clearly any crisis is going to be hair-triggered by the Fed's management from its exit of QE (or not as the case may be). Dudley has therefore positioned himself as the FOMC's gatekeeper to thinking and guidance on how this will play out.

This backs out into the management of asset prices, just as the execution of QE did. If asset prices crash, the Fed will slow (perhaps even reverse) the QE exit. If asset prices spike, the Fed will accelerate the exit. Presumably the Fed has a target for the S&P, Dow, NASDAQ etc and various yield spreads, which it deems to be consistent with the level of economic activity desired; and will then manage the basis between these target prices and the daily fluctuations created by speculative attempts at price discovery of these target levels. The New York Fed's job is to manage this basis risk. Someone has already eponymously named this process as the "Yellen Collar" - [xv].

Bottoms were audibly squeaking a different tune in Washington last week. Having failed to find support in Europe and now facing the firing squad at home, Yanis Varoufakis ventured to Washington looking for cracks in the Troika - [xvi]. It was an inspired move, given that America is less than happy with its European allies for threatening its hegemony by signing up for China's AIIB. Following his earlier wake-up call on the matter, Larry Summers "op-Edded" on the issue in the Washington Post - [xvii].

Varoufakis made sure that the IMF was paid in full - [xviii]; however his appositely named deputy Mardas signalled where Greece would like all its debts to be financed from. As usual Nazi war reparations are the source of funds, which Greece now estimates at 279 billion Euros - [xix]; a number that would effectively remove all its debts and leave a tidy surplus for an economic stimulus post "Grexit".

Whilst Varoufakis was playing "Bad Cop" across the Atlantic, Tsipras was playing "Worse Cop" behind the newly emerging Iron Curtain. In order to exploit rifts within NATO and also between NATO and Russia, Tsipras met with President Putin and chalked in some symbolic energy for agriculture barter deals; which may come in handy after the "Grexit" when there is no hard currency in Greece - [xx].

Epoch of Belief, Epoch of Incredulity (14) "Get Long the Dollar for Good on Friday" reported that the BOJ was preparing for the next wave of QE on April 30th. The lone figure of dissent Takahide Kiuchi had called for an end to QE - [xxi]. Kiuchi was soundly outvoted last week, as the BOJ re-affirmed its commitment to monetary stimulus - [xxii]. The BOJ did not move to expand the stimulus however, which supports the view that the next stimulus will involve the purchase of ETFs and J-REITS as Kuroda has hinted previously.

God Bless

God Bless.

- [xxii]

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