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posted on 11 May 2015

Epoch of Belief, Epoch of Incredulity (18) Conspiracy Theorists

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Many conspiracies were revealed last week. The Fed and the BOJ took centre-stage first, as currency markets focused in on signals emanating from the Dollar-Yen.

Abe's adviser Kozo Yamamoto hinted that there are some BOJ governors pushing back against further policy easing, referring to them as a "den of conspirators" - [i].According to Yamamoto, patriotism and the pursuit of inflation demand that legislation must be amended in order to legalise this inflated manifest destiny.

Wages seem to be normalizing quite nicely, so the pressure to continue with dramatic "Q-easing" is allegedly off. This enthusiasm must be tempered by the fact that Kuroda actually admitted that the BOJ will miss its 2% inflation target over its two year target period - [ii]. There is therefore still great scope for the BOJ to expand its monetary stimulus.

The BOJ was happy to take a wait and see stance at its latest meeting - [iii]. The would-be "conspirators" seem more worried about the health of the US economy than their own. America is slowing rapidly, which has negative consequences for Japan; that could be amplified by a strengthening Yen versus the US Dollar. Falling oil prices additionally frustrate all attempts to hit the 2% inflation target; and since they correlate negatively with the US dollar the outcome is even more obscured. The BOJ therefore wishes to see how the US slowdown unfolds, before committing to further monetary stimulus.

Just to lay down the marker for the next easing step however, the BOJ revised its inflation projection lower.... Yen bulls take note, lest you get carried away. The US Q1/GDP data - [iv] signalled that things slowed considerably over the quarter. This can be attributed to the stronger Dollar and the collapse in the energy sector. Many commentators, including the FOMC, tried to claim that the inclement weather was the real source of weakness that will prove to be temporary.

Whatever the cause, Wall Street economists all scrambled to revise down their growth estimates for the rest of the year - [V]. The FOMC meeting and announcement therefore looked like a conspiracy to deliver on some form of rate hike later in the year, in order to appear consistent with guidance, whilst leaving the door open to a more data dependent neutral bias going forward from this tightening event - [vi]. Consequently, the yield curve flattening trades went on in spades. Should the curve then continue to invert, traditional fundamental analysts will be calling for a recession followed by further monetary stimulus from the Fed. It would seem that the US economic recovery from the Credit Crunch has just gone on pause; the duration of said pause now depends upon global growth prospects in general.

As the conspiracy to allow Greece to default without "Grexiting" evolved, the Greeks reshuffled their negotiating team along conspiracy lines. Varoufakis was therefore benched - [vii]. He then suffered further ignominy, when his wife beat off an attack by Anarchists as he cowered behind her in a restaurant - [viii]. Prime Minister Tsipras also strongly hinted that the compromise, that is being conspired, will then have to be presented to the Greek people for acceptance - [ix]. The Greek people can therefore reject the deal, yet still vote to remain in the Eurozone. The absurdity of a default without a Grexit was therefore introduced into the mix.

Another classic Eurozone deal is on the cards. The ECB signalled that such a deal was in the making, by extending emergency financing to Greece; in a move which stands in stark contrast to its willingness to allegedly cut Greece off the week before - [x]. Going into the weekend, there is optimism that a deal will be struck with Greece's creditors by Sunday - [xi].

This would come as a great surprise to the investment community, based on a poll last week that found a strong consensus for the Grexit as the most likely outcome - [xii]. It would not however surprise Jeroen Dijsselbloem, who hinted strongly that there is a plan-B - [xii], even if Greece defaults. A quick course in semantics may be needed for many, to understand that a Greek default does not automatically mean the Grexit.

Adding to the air of cautious optimism developing in the Eurozone was the latest bank lending data, showing the first increase in 36 months - [xiv]. Optimism is now triggering levels at which some commentators are asking if there is any need for further QE from the ECB - [xv]. Such an inflection point, combined with the weakness in America, has profound implications for the Euro. Suddenly the Euro is looking well bid, especially after the weak US GDP data and the equivocal FOMC announcement. This bid also seems to be fundamentally supported by the recent flow data - [xvi];which show investor appetite increasing for European exposure at the expense of America, Britain and Japan.

Given that sentiment is still overwhelmingly bearish on the Euro, a nasty surprise beckons for the Euro bears.

Drilling through the data, the US equity bet has been replaced with a fixed income bet; which lends itself to the weakening economy and curve flattening theses.

In Europe, the equity bet is taking over from the fixed income bet; as the bet moves from what Draghi will do to create growth towards the consequences of his growth policy. Britain is a tiny version of America, for similar reasoning. The real problem with Britain is that the flows are anaemic. This reflects the fact that it has become an afterthought, after all the other major asset allocations have been done. During the crisis, this was a blessing, because British assets avoided the heavy selling that its trade partners endured.

This weak flow signal also reflects the fact that the Hung Parliament outcome is not something that investors readily relate to.

The confusion is magnified by the ineptitude of the main protagonists and their hysterical attempts at trying to relate to the British people. Japan shows no bias between the two asset classes; reflecting the dilemma facing the BOJ discussed earlier. Global investment flows in general appear to be very rational; and hence sustained by the global-macro fundamentals.

One flow (or rather lack thereof) chart which is rational and most interesting, is that of the cash balances held by Private Equity. A veritable war-chest has been patiently accumulated, during the late recovery phase, by the private equity conspirators - [xvii]. Presumably they have been waiting for the adverse impacts of the Fed's impending tightening to set in, before deploying their "dry-powder" on the distressed assets that they expect the Fed tightening to create. Private Equity cannot be very happy with the way things played out last week. The anticipated crisis entry point has not only been pushed back in time, but has also been fundamentally questioned by the events of last week. Private Equity must be getting an itchy trigger finger, especially since it is not earning fees on the commitments that it has not deployed.

A more worrying flow chart is evinced by the level of NYSE margin debt - [xviii]. Combined with the earlier flow data from Markit, it would seem that the real money is now selling US equities to the margin buyers. An uptick in margin costs, from a Fed tightening, could easily trigger the nasty little correction that the wall of private equity money is waiting for.

The PBOC is conspiring to breathe life back into the state owned sector of the economy. The latest monetary easing is much more nuanced than its impact on the equity market suggests. The easing is occurring against the threats of bankruptcy and defaults in the property sector. Closer analysis shows that the policy banks are being recapitalized and local government debt is being repackaged to appear less toxic - [xix]. The PBOC hinted that it will be underwriting this whole restructuring process, last week with a suggestion that it may expand its Pledged Supplementary Lending (PSL) programme - [xx]. For the credulous investors, who have been dazzled by the gains in the equity market, this expanded PSL programme has been framed as something equivalent to the ECB's successful Long Term Refinancing Operation (LTRO).

In China there is no equivalent of Jens Weidmann and the Bundesbank, to opine against the heresy of deficit monetization, so the PBOC is now attempting to get away with it. For the speculators, the inference is that the PBOC is now underwriting the capital gains in the equity market. In practice, the capital gains are the smokescreen to disguise the latest bailout of the state controlled sector of the economy.

The PBOC is therefore now using the country's foreign exchange reserves to bailout the state controlled sector of the economy. Ultimately, this has very negative consequences for China's economic position in the global economy; however until the estimated $3.7 trillion of reserves is all spent on this endeavour the final reckoning will not occur. Before then however, it is reasonable to assume that China's trading partners will signal their frustration that the reserves have not been recycled to rebalance the global economy. China's apparent reluctance to consume more is a systemic problem.

The Chinese remain avid savers - [xxi], therefore there is unlikely to be any global rebalancing soon. This saving propensity, was first exploited by the government to create the overcapacity in the state controlled industries and property sector that are now evident. Having created a bubble in fixed assets, the bubble has now been transferred to financial assets; as the PBOC seeks to address the consequences of the overcapacity from the fixed asset creation.

This propensity to save combined with the financial asset bubble created by the latest wave of monetary easing, may someday lead to what is known as the wealth effect in the West. If and when this phenomenon is achieved, the Chinese may feel sufficiently wealthy enough to start consuming like their western trade partners.

If the Chinese financial asset bubble bursts however, the saving habit of the Chinese is most likely to be reinforced. There is therefore little prospect of global imbalances being resolved any time soon; and an added risk that they may be made worse when the Chinese financial asset bubble bursts.

- [xxi]

- [xx]

- [xix]

- [xviii]

- [ixvi]

- [xvi]

- [xv]

- [xiv]

- [ixii]

- [xii]

- [xi]

- [x]

- [ix]

- [viii]

- [vii]

- [vi]

- [V]

- [iv]

- [iii]

- [ii]

- [i]

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