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posted on 22 April 2015

Epoch of Belief, Epoch of Incredulity (16): May the Force be with Who?

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As all the world's an FX trader right now, it's useful to understand how policy makers would like the sheep that make and follow trends to behave.

Last week belonged to the IMF, or rather to Christine Lagarde. The institution tried to drive the sheep long US Dollars with the story of a structural Dollar bid; predicated on an alleged $9 trillion systemic short position in the currency - [i]. If the world is short US Dollars, this suggests that someone(s) on another planet(s) must be long them. Presumably the IMF will soon inform that the New World Order is now the New Galactic Order and that Earth has dangerous structural twin deficits with the universe! Based on the stories the IMF told last week, the New Galactic Order seems very plausible in comparison.

George Osborne could probably do without alien IMF interference at the moment, as he sells his personality and policies to the British polity. The IMF initially did the Tories a great disservice, with a report which concluded that the UK economic recovery is too weak to put a dent in the deficit - [ii]. Furthermore, the IMF hinted that a more expansive fiscal policy would be needed; to create the kind of growth that will ultimately yield the tax revenues to pay down the deficit. This damning piece of electoral interference was swiftly overruled, by the omnipotent Lagarde the following day, when she gave Osborne and his economic plans a clean fiscal bill of health - [iii].

The cosmic sentiment being created by the IMF, is that the US Dollar is "reorganising the world order" - [iv]. Allegedly currencies which are pegged (officially or otherwise) to the Greenback, most notably China's, will undermine their economies; and countries that devalue will prosper. Commodity producers will also take a hit, since their exports are priced in Dollars. This all sounds like policy maker code for the ECB, the BOJ and Asian central banks to open up the taps even more, rather than for the Fed to turn its tap off.

This nuanced approach to global money printing, therefore appears like a Fed tightening singularity event; even though the Fed actually remains easy. Equity markets and risk assets in general should love the story, once they get it. The Chinese clearly have already got it. The IMF exaltation for central banks to ease, must however be tempered with an overlay of the impact of the falling oil price.

"Cheap Oil's Winners and Losers in One Giant Map - [v]"

- [v]

For some economies, notably in Asia and Europe, the fall in oil prices has already dwarfed any monetary stimulus that their central banks could pass on to their real economies. The pressure on Asia and Europe to ease therefore, has been mitigated by the big fall in oil prices. Talking about the oil price drop as a deflationary risk, which needs QE as the remedy, is now a little disingenuous therefore. Central bankers began to take back this meme last week; and replace it with a new sublime message that the threat of deflation is now waning - [vi].

America is however less of a beneficiary from falling oil prices, because its economy has become a petro-economy thanks to the Fed's QE stimulating overcapacity in the Shale Oil sector. The Fed therefore is just as inclined to ease as the ECB, or any other Asian central bank for that matter. This of course means that the Euro, the Yen and other Asian currencies have a very strong fundamental floor underneath them, based on the support of the low oil price. Welcome to the data dependent multiverse, traders and central bankers.

The Saudi's have just doubled down on increased production; in an attempt to break the new unholy galactic alliance between America and Iran; which is mirrored in the oily alliance of US Shale and the expanded Shi'ite controlled Iraqi crude production - [vii]. This mutual assured destruction will hurt all parties involved; in an economic war of attrition that gradually takes out the higher cost production sources, until global supply comes back into balance with demand.

Echoing Kuroda's initial signals that the next BOJ easing wave would be focused on J-REITs and ETFs; the IMF called for the BOJ to expand its operations to buy longer dated JGB's and private assets - [viii]. Prime Minister Abe was basking in the glory of local election victory - [ix] last week, which could be interpreted as a referendum yes vote on QE; so what was holding the Yen up? The obstacle appeared in the bespectacled figure of Abe's adviser Koichi Hamada. Hamada caused the Yen to stop its fall and begin to reverse when he called the decline dangerously overdone and in need of a retracement to 105 versus the US Dollar - [x].

To support Hamada's caution, there is also a school of thought in Japan; which says that the official inflation estimates are missing items that would put the inflation rate well on track to meet its 2% target - [xi].His views are allegedly shared by some on the BOJ board, who have privately signalled that the strong Dollar trend may not be their friend. They rationalise that the strong Dollar is a headwind for their greatest ally America - [xii]. If the American economy starts sneezing, Japan will therefore catch a cold.

Mr Kuroda is also on record, from last week, suggesting that inflation is coming along nicely - [xiii]. Taking all points into consideration, it appears that the BOJ is happy to sit back and let another central bank make its move to ease; or even for the Fed to "tighten" Dollar-Yen higher.

The Fed is unlikely to oblige the IMF or the BOJ with any enthusiasm. The strong Dollar, in and of itself, has become a headwind similar to a tightening of monetary policy. The Fed is therefore more inclined to let the Dollar momentum run its course; and then see what the economy has done in response, before making a more considered move on interest rates based on the domestic economy. The word out of the S&P 500 companies, is that the strong US Dollar is their number one concern - [xiv]. Even the Hawk Jeffrey Lacker is starting to sound less Hawkish. Whilst calling for a June rate hike, he adjusted his position; by saying that after this event that the Fed will be free to act data dependently going forward - [xv].

The latest polled economists' consensus now sees the first Fed rate hike in September rather than in June - [xvi]. Noises out of the Fed last week remained as equivocal as ever. Whilst Mester is calling for a June rate hike - [xvii], Lockhart is now saying that the "murky" data in Q1 mitigate for delay until Q4 - [xviii]. Of this "murky" Q1, Stanley Fischer believes that stronger growth will show itself over the remainder of the year - [xix]. Such equivocation is supportive of the new consensus on the delayed timing of rate hikes.

Next on the list of usual suspects on the IMF hit-list was the Eurozone. The Eurozone and the ECB are however a tough call; after Draghi's inspired no brainer bet against the Euro in Q1. In Spain, Podemos is now suffering a dirty tricks campaign; that links its funding to Venezuelan backers - [xx]. Having seen what has happened to Greece, due to its links to Putin, sentient Spaniards are starting to distance themselves from Podemos and Popularism. The ECB has continued to make noises about QE showing up in Eurozone lending and growth data - [xxi], so there is little to drive the Dollar higher there either.

Italy is clearly showing signs of economic reforms, in relation to the wave of corporate merger activity that is going on there this year - [xxii]. Whilst the ECB is unlikely to tighten and take away this backdrop of financing economic reform, it is also clear that it no longer needs to step on the gas with more liquidity injections.

Last week, the FT reported that the ECB is running out of German Bunds to buy - [xxiii]. The result has been a painful squeeze in the German repo markets, where there is no collateral - [xxiv] available for securities lending. A Grexit will potentially trigger the kind of squeeze which leads to delivery failures, which then threaten financial institutions themselves. QE has therefore hit a technical brick wall that may become inflamed further by the Grexit. Without the ECB directly incurring credit risk and taking on the unprecedented role of a corporate financier in the bond markets, the situation looks dicey.

Draghi must now have his fingers crossed, hoping that QE will work swiftly; otherwise he will face an awkward meeting with Jens Weidmann, to explain why national central banks now need to start buying lower quality corporate bonds. Germany has a budget surplus, and that will only compound the scarcity of Bunds - hence Draghi's dilemma. Only Greece threatens to drive the Euro lower. The IMF officially noted that negotiations with Greece are "not working" - [xxv]. The ECB's Klaas Knot said that contagion from Greece is a risk that may spread - [xxvi]. Wolfgang Schaeuble then struck the fatal blow, when he opined that financial concessions were not on the table; and that the Greeks now have to implement the painful reforms that they have procrastinated over this far - [xxvii]. Since it was her week, it was left to Lagarde to push Greece over edge when she said that she will not give Greece any more time to make its next payment to her institution - [xxviii]. Varoufakis was said to be setting up one final role of the dice in Washington with President Obama.

Having just shaken hands with the devil in Moscow, the Greeks seem to think that this will scare the Americans into forcing concessions from the Europeans. News of the impending meeting with Obama was then followed by a leak, alleging that Greece had already technically defaulted - [xxix]. Perverse Greek behaviour has just been timed out. The scene for the Grexit has therefore been set up; however even this has yet to trigger a further stampede out of the Euro, suggesting that this singularity event is getting priced in.

The consensus, being reported in the press - [xxx], is that Draghi has done enough and will do whatever it takes to restore calm and tight yield spreads in the event of the Grexit. Contrarians come out to play!

The last suspect on the hit-list was China. Chinese reserves have accelerated their slide - [xxxi]. The official take on this, is that there is capital flight from China; driving the Yuan lower in consequence. Clearly also, the value of reserves in currencies other than US Dollars will have been eroded because of the Dollar's rise. The latest US TIC Data revealed that Japan has now overtaken China as America's greatest creditor - [xxxii]. It may also be that China is in fact now using its Dollar reserves as collateral to finance its latest monetary stimulus. This would also explain why the PBOC is so keen to have the Yuan achieve reserve status as soon as possible. If the Yuan had reserve status, the capital flight out of it would not be as aggressive.

China is therefore currently forced into selling Dollars, in addition to other reserve currencies, in order to support the value of the new Yuan that it is creating once they get dumped during capital flight. Since China has more Dollars than anything else, this selling pressure is what will be felt most in the FX and US Treasury Bond Markets. Thus far, the corollary domestic economic stimulus has only been seen in the Chinese equity markets and not the real economy; since this is where all the new Yuan are heading first as they get exchanged for financial assets rather than real economic assets. China is thus financing a speculative asset bubble, by the selling of its reserves and the creation of Yuan out of the proceeds. China is no longer sterilizing its reserve accumulation.

The problem is however that Chinese exports are also down, so that reserve accumulation of export revenues by the PBOC is no longer providing a cushion. China is thus selling its Silver, rather than accumulating it; as it once did as a prelude to the collapse of the Middle Kingdom at the hands of colonial invaders and Opium sellers. No wonder observers are only seeing the capital flight component of the reserve monetization.

Even Chinese fire-work makers are getting into financial services - [xxxiii] these days; which suggests that the bubble phase is well past its infancy. China is now exchanging hard currency for spurious domestic economic activity. The authorities tried to take the steam out of things, by allowing more equity short selling; and curbing the purchases of equities by trusts created out of shadow lending - [xxxiv].Such measures can only act as temporary brakes however, if the speculators have correctly read that China is creating new currency out of its reserves.

Against this backdrop, it is hard to see the Fed pulling the rug from underneath the capital markets by tightening aggressively just yet. The Fed must wait to see where the Chinese US Dollar selling pressure shows up. If its shows up in the bond markets, then the tightening is off. If it shows up in the FX markets, then a tightening may be needed to support the US Dollar. Other central bankers will have to react to the PBOC and the Fed's response to it. If relations between America and China deteriorate further however, the Fed will doubtless do the patriotic thing and tighten to strengthen the Dollar and collapse the Chinese bubble. FX traders take note.

- [xxxiii]

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- [xxii]

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- [xvii]

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- [XV]

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- [xi]

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