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posted on 18 May 2015

Epoch of Belief, Epoch of Incredulity (19): Inflated Expectations

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Inflated expectations for a deal between Greece and its creditors that avoided being labelled as the Grexit, were evident at the credit rating agencies last week. The agencies agreed to play along with the charade by promising not to downgrade Greece, even if it misses a scheduled debt payment - [i]. By so doing, a technicality that allows the ECB to keep emergency funding in place was maintained.

The Greeks however must now reciprocate, by negotiating in good faith; rather than taking the continued ECB emergency funding support as a signal that they have a stronger bargaining position from which to extract greater concessions from their creditors. If past performance is any indicator of future performance, the Greeks will not reciprocate with the kind of alacrity that their creditors demand.

Inflated expectations were also evident in the change in sentiment regarding growth in the Eurozone and the need for further QE from the ECB. This change was underlined by last week's PMI data, which suggested that manufacturers are raising their prices for the first time in eight months - [ii]. Italian manufacturing data - [iii] showed that Renzi's reforms plus Draghi's QE continue to have a positive impact. Spain also continued to diverge positively from the EU PMI average; and especially from French economic stagnation - [iv].

Implied forward Eurozone inflation rates - [v], now suggest that deflation fear has been replaced by inflation expectation. The Eurozone PMI data was then followed with a raised growth forecast from the EU - [vi]. This sharp change in sentiment has now eroded all of the rally, in European government bonds, that the ECB decision on further QE had created in Q1 - [vii].

Greece was however tactically omitted from the raising of growth expectations and predictions - [viii]. This omission is contentious. The Troika will argue that Greece needs to reform in order to generate growth; and the Greeks will no doubt argue that this lack of growth reflects the enforcement of the Troika's austerity conditions. The Greeks then applied their characteristic prevarication, in relation to negotiations, on the technicality that the IMF and EU did not have a consistent position. The IMF is focused on economic and pension reform, whilst the EU wants adherence to deficit targets. The Greeks seem to think that these conditions are mutually exclusive; and would therefore like the Troika to drop one of these constituent sets of conditions.

One has to admire the Greek eleventh hour chutzpah; and as we will see there may be more to it than sheer bravado. The ECB responded to this provocation by signalling that Greece will effectively be frozen out of the capital markets, when unnamed officials leaked that details of a plan for new collateral value haircuts to be affixed to Greek bonds - [ix] were under discussion. The application of said haircuts is conditional upon Greek negotiating style - [x].

The liquidity tightness, of the ECB's Gordian Knot, is already being felt in the Greek banking system - [xi] but on the other it has effectively stalled further capital flight, so that there is method in the apparent cruelty of the ECB.

Jean Claude-Juncker gave away the choreography for a very European solution - [xii]. Greek attempts to drive a wedge, between the IMF and the European members of the Troika, were framed by him as an "Anglo Saxon" attempt to take down the European Project. Since the European Project began as a Cold War "Anglo Saxon" initiative, Juncker's inflammatory comments suggest that the "Anglo Saxon" influence is no longer welcomed by its creation. Presumably however, if and when the fighting starts again on the eastern and southern borders, the "Anglo Saxon" creators will be welcomed back again as liberators.

Given that Britain was on the eve of a general election, in which a referendum on Europe was the subliminal core issue, Juncker's invective had a little more resonance to it. The pusillanimous UK press machine made sure that Britons had not been fully informed that they were in effect voting on being governed by Brussels (and Holyrood!!!) versus an attempt to return to non-PC "Anglo Saxon" democratic values.

Some voters thought it was about the NHS, others the Deficit(s); and some others even thought that it was all about bacon sandwiches. The issue of immigration was the little tell signal, which indicated that there was an implicit understanding by a sapient majority who feel that the real issue is sovereignty. Also given the fact that the anniversary of VE Day came two days after Juncker's comments, it was clear that a new paradigm shift in Europe was being auspiciously heralded.

The EU is therefore willing to blame the perfidious "Anglo Saxons" for Greek perverseness. It would also seem that the EU is willing to stiff the "Anglo Saxons", on their pound of Greek flesh, in order to preserve the European Project. Further credence to this thesis was created, when Wolfgang Schaeuble then followed Juncker's lead by opining that the case for further conditional aid for Greece was in German interest - [xiii]. Merkel then swiftly brushed over the overt Germanic influence, before it became too obvious, by saying that "European solidarity" was called for - [xiv].

The stiffing of the "Anglo-Saxons" is a new Dunkirk moment; and something that they will presumably not take lying down. Effectively, the EU has announced that it is a global superpower. The sublime message is that Germany is the real superpower within the superpower. President Putin and many an Islamic Fundamentalist will also have taken note of this great schism within NATO; and also of the riddle, wrapped in the mystery inside the enigma that is Germany.

David Cameron has already intimated that he is not up for the impending sovereignty battle; but as luck would have it Boris Johnson was elected as an MP, so that he can take up this baton when Cameron leaves office. The threat from the rampant SNP, in addition to the fun and games in Europe, can only have brought forward the "Brexit" timetable. The real election result is from the North, where the Tories need to become more like UKIP in order to have the overall majority in Westminster that they crave. Johnson has already prepared for this scenario and is now set to officially reach out to the UKIP faithful. As the unelected and unelectable Farage goes back to the pub for last orders, Johnson's job will have become much easier. The "Blue Labour" - [xv] project is making great progress.

All the parties need to get in touch with their feminine sides going forward however, since all the alpha-male stuff in British politics ignores the fact that female voters are now the critical drivers. Had UKIP been more attractive to women voters, things would have been a lot different on the day. One look at Nicola Sturgeon should leave political strategists in no doubt about this.

Prime Minister Cameron returned to Downing Street, mumbling his "One Nation" line. This must now be reclassified, to take into account impending Scottish devolution and the "Brexit" from Europe. The positive sentiment for Sterling against the Euro, alluded to in Epoch of Belief, Epoch of Incredulity (17) "Hope and Glory" will now swiftly evaporate - [xvi].

Inflated expectations, in the form of inflation expectations, were however strongest in America - [xvii]. Various indicators ranging from breakeven inflation expectations, through commodity prices, to ETF flows are all discounting at least the end of the deflationary cycle; if not the beginning of the inflation cycle. The Fed will therefore feel obliged to respond rationally, by tightening credit, which will then no doubt create further economic weakness that swiftly ends the tightening cycle.

Global inflated expectations appear to have even reached the Antipodes. The RBA had sufficient faith in the strength of the Aussie Dollar to deliver another rate cut, coincident with a signal that it is confident that there is fundamental strength in the consumer - [xviii]. The markets read all this as the last rate cut in the Australian interest rate cycle.

All this inflated expectation, dramatically named "The Death of Deflation" - [xix], was apparently confirmed by the 30 year US Treasury Bond breaking down below a 200 day moving average. It was also the death of the P in P&L for many who had continued to bet on the deflation theme.

As Jeffrey Gundlach was opining - [xx], that High Yield is the worst place to be in a rising interest rate environment, this scenario was playing out in real time - [xxi].

The Federal Reserve ever mindful of the reality, that it will get blamed for the fixed income rout and also the period of slow growth that follows, started to prepare its response to the unfolding tragedy. By strange coincidence a new research paper - [xxii] into credit spreads (and how to read them correctly!) was delivered with alacrity by David Lopez-Salido, Jeremy Stein, and Egon Zakrajsek. This was a paper for quants, so its full implications are likely to be lost on the vast majority of those who are currently headed for the illiquid exit from bond and equity markets. It could be said that the price action created by those who are unaware, of the import of this paper, is also required to trigger the conclusion and Fed policy action that the document implies are both coming. To cut a long story short, the paper finds that (in their own words):

"More specifically, we establish two basic findings about the importance of time-variation in the expected returns to credit-market investors. First, using almost a century of U.S. data, we show that when our sentiment proxies indicate that credit risk is aggressively priced, this tends to be followed by a subsequent widening of credit spreads, and the timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity."

For the uninitiated, this means that the current period of credit spread widening will precede an economic contraction; this is however not the "Big One" that Bill Gross was anxious to rebuild his reputation with by calling last week - [xxiii]. The reader should note carefully that the Fed research paper indicated a period of credit spread widening, rather than a period of rising interest rates per se.

This suggests that the currently expected Fed tightening will be far less in magnitude than what is anticipated and being discounted into widening credit spreads. The Fed is hoping that a hard landing in the credit markets translates into a softer landing in the real economy. Once again, the Fed is expecting the market discounting mechanism to do its real tightening for it. For this to occur, lots of sellers need to head for the exit in the bond and equity markets simultaneously.

If the second order softer economic landing then looks a little harder in the data, the data dependent Fed will respond with easy money again; by which time the collapse in the credit markets will have got all the players (including Gross) begging for the Fed to respond in this way. At this point, the real contraction in credit spreads that portends the next major asset bubble will be under way again.

Gross's positioning for his alleged "Short of a Lifetime" in German Bunds, suggests that there is far less conviction behind all of his recent headline grabbing. His fund positioning - [xxiv] was for Bunds to remain in a tight range; suggesting that he understands the import of the Fed's recent paper on credit spreads and is looking for an entry point, to the "Long of a Lifetime", as the Fed triggers a risk-off event. Asset gathering and asset management make for strange bedfellows, especially when a portfolio manager's actions contradict his corny sales-pitch. It's a dirty business and the smell of Buy/Sell (B/S) is becoming overwhelming.

Janet Yellen added to the stench, when she opined - [xxv] that the US stock and bond market valuations are "Quite High" in her opinion. Clearly Yellen would like to accelerate the stampede for the exit; and does not feel that the Alpha's and Omega's in the Fed's research paper on credit spreads are creating enough selling momentum. Her opining had the desired effect; and the US 30 Year moved above 3% in yield triggering a panic in the equity market.

It smells like Exter's Inverted Conspiracy (Epoch of Belief, Epoch of Incredulity 18: "Conspiracy Theorists") is festering away nicely folks.

As some vulgar "Anglo Saxons" give the Germans the old "V" for victory sign, as they celebrate VE Day, it is perhaps worth paying some attention to the emerging foreign policy paradigm coming out of Washington in response to the latest multilateral threats to "Anglo Saxon" hegemony. This paradigm shift was framed by the release of the latest Quadrennial Diplomacy and Development Review (QDDR) - [xxvi] from the State Department. The big take away from this document was the emergence of Climate Change as a core element in US foreign policy; and its equivalent ranking with democracy and economic prosperity in the Pantheon of State Department idols.

Those who think, that Americans are a bunch of carbon burning climate change deniers, should note that this is an exclusive privilege which does not extend to the rest of the world. This privilege was earned in 1945 and is unlikely to be given up without another fight in 2015, although other emerging superpowers may think otherwise.

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