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posted on 25 May 2015

Epoch of Belief, Epoch of Incredulity (20): Keep Your Friends Close and Your Economists Closer

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A recent study by the University of Muenster, based on empirical evidence taken from the US Congress - [i], found that Politicians who hold undergraduate degrees in economics are significantly more likely to engage in corrupt practices than their colleagues. Whilst this is startling in itself, the implications for central bankers, who are all grand masters of the dark art, is astonishing. Quantitative Easing may be the greatest financial scandal of all time. Ben Bernanke's recent career change into the world of hedge funds and asset management, closely mirroring that of his nemesis Larry Summers, illustrates the subtle payoff received by such doyens of the oldest profession in the finance world.

Faced with such insurrection, Senate Banking Committee is once again trying to extract a modicum of accountability from the Fed. Committee Chairman Richard Shelby reached out to Democrats last week; in an attempt to devolve more power to the regional banks and ease their burdens under Dodd-Frank - [ii]. In the typical Pavlovian response a Fed Dove, this time John Williams, responded with the typical signal that monetary policy will have to be tightened sooner rather than later; in a characteristic attempt to demonstrate Fed independence from the easy money crowd on Wall Street. The Fed apparently still doesn't get it.

Senator Shelby doesn't want tighter credit per se, he wants credit decisions devolved to the regional banking members of the Federal Reserve System. The Fed now risks making a weakening credit and capital markets background much worse, by being overzealous with monetary tightening in a market that has already significantly tightened credit in anticipation of the FOMC.

To head off this developing accident, the Charles Evans' Dovish Chicago Fed put out its own research - [iii]; which shows that the natural rate of unemployment is now much lower than before the Credit Crunch. Reading between the lines, the Chicago Fed is trying to signal that unemployment can fall a lot further before the FOMC needs to start tightening.

Dr. Yanis Varoufakis teaches young students of the dark art of economics how to excel, in addition to his daytime job of applying the skills he has learned to negotiate with the EU. Epoch of Belief, Epoch of Insecurity (19): "Inflated Expectations" suggested that the Troika was becoming divided, as the negotiating skill of the Greeks exploited some fundamental differences between the creditors. This schism widened to such an extent that markets began to pay attention last week. Allegedly the EU wants the IMF's rigour in the current bailout negotiations, but does not want the IMF's oversight of Greece's absolute debt sustainability going forward - [iv].

Loosely translated, this means that a bailout which favours the EU is being concocted; and also that the IMF is no longer welcome in future Greek debt discussions. As was reported in Epoch of Belief, Epoch of Insecurity (19): "Inflated Expectations", the "Anglo Saxons" have been stiffed. Gerry Rice, the IMF spokesman, gave the first "Anglo Saxon" response to this "Stiffing", when he opined that the institution was in favour of any deal that "needs to add up" - [v]. For "add up", read economic; the importance of which will become later. The "Anglo Saxons" clearly view the issue as a pecuniary one, which us fundamentally different from the Europeans who view it as political.

This "Stiffing" was further underlined by Wolfgang Schaeuble, who opined that Germany will do everything it can to keep Greece in the Eurozone under "justifiable conditions" - [vi]. For "justifiable" read "political" and also read "German". Schaeuble and Merkel still have some wood to chop though; in order to sell the emerging EU bailout that "Stiffs" the "Anglo Saxons" to the German people. There is still a strong feeling, even within Merkel's own party, that Greece should be forced out of the Eurozone - [vii]. Schaeuble and Merkel will therefore have to open up to their colleagues a little more, about their grand Teutonic "political" strategy for Europe, in order to elicit the desired patriotic response.

The Greeks meanwhile continued to play off all sides of the Troika, by paying the IMF the 750 million Euros owed within hours of the payment deadline - [viii]. This payment was more of a book-keeping switch than a net repayment from Greece to the IMF however - [ix]. The payment was facilitated by a transfer of funds already held at the Greek's emergency account at the IMF to the account required for repayment. The Greeks are therefore robbing Peter to pay Peter. Peter in this respect is the IMF. In return the EU was then nudged into accepting that Greece had made progress on some economic reforms, but needed to go even further - [x]. The pace of negotiations is now being controlled by the Greeks, which is a significant initiative for them to seize.

The Danes gave the signal that the situation is unsustainable; and also hinted that a further haircut is coming for Greek debt owners. This credit event may then have knock on effects across all Eurozone bond portfolios. The Danish banks have taken the pro-active stance of admitting that Greek sovereign debt does not deserve the AAA risk weighted capital valuation that it commands on their balance sheets - [xi]. Greek debt will now have to be priced as junk; and the losses will have to be taken, in addition to the raising of new capital to absorb said losses. The Danes have begun the process by taking the first step of the journey, admitting that their Greek bonds are not AAA.

The recent sell-off in European sovereign debt, in any case may have made the Danish action redundant. The threat is now that other EU nation debt held by the Danish banks must now be re-priced, to reflect the inherent default risks. Once the Danish banks have taken the hit, it then begs the question of all the other Eurozone banks that have not followed suit. Mario Draghi must be starting to squirm. Having managed to compress sovereign bond spreads, with QE that creates implied AAA ratings across the board, the whole fruits of his endeavours are swiftly unravelling.

On the positive side, rising yields support the Euro and therefore give him scope to do some more bond buying. It is amusing to reflect that Draghi was once blamed for making sovereign bonds scarce. Those who still want to buy will now find plenty available at very attractive yields. Since yields are rising however, it is unlikely that the original buyers who were concerned about scarcity will be there on the bid any-more.

Draghi's squirming was audible in Washington last week at the IMF's latest junket. He emphasized that QE is "potent" and is working - [xii]; but also that it needs the full nine-yards to be successful - [xiii]. We are going to get the full QE whether it is needed or not. His hastily delivered comments were made to arrest the sell-off in European bonds; so that rising interest rates don't kill the patient and force him to buy even more debt.

Unfortunately however, bond investors are now looking to exit in general; and will use the ECB as the bid that they can hit to get out. He could still be faced with a scenario of rising interest rates, during execution of the next round of QE, which would be amusing. Ironically, rising interest rates are exactly what is required to trigger bank lending; so he will ultimately be able to take credit for being lucky rather than smart.

As the dust settled in Britain, after the momentous events of the General Election, the "Blue Labour" project made further substantial progress. Boris Johnson is now in the Cabinet Room (sans portfolio) - [xiv]; and faces off against George Osborne, as David Cameron prepares to bow out gracefully.

Johnson declared his intentions and capabilities by eating a bacon sandwich - [xv], the choice of pretenders to Number 10. Osborne has been given the short straw, of renegotiating the UK's relationship with the EU - [xvi] with the spectre of the UK referendum hanging over his head, to choke on. In the meantime, Nigel Farage has been swiftly persuaded to rescind his resignation letter by the UKIP faithful - [xvii] as the referendum comes into view. Farage's return seems set to split the party, as if by magic, thereby creating an opening for Johnson to exploit - [xviii].The door is now open for Johnson to reach out to UKIP and for both to stab Osborne in the back; if and when Osborne chokes on the negotiations with the EU and thus undermines his chances of leading the Tories. Johnson will then save the party, by bringing UKIP into the "One Nation" broad church, or so the story according to Rupert Murdoch will go. Just to give things a little nudge, Osborne promptly responded by saying that he will be "resolute and firm" in his negotiations with the EU - [xix]. Cameron hinted that the date for the in/out referendum may be brought forward to 2016 - [xx], in an attempt to get the EU to fight on British terms. Wolfgang Schaeuble accepted the challenge, but refused to fight on Cameron's terms, by replying that the EU "won't be rushed" - [xxi].

The sparring has thus begun.

"The Greek people can therefore reject the deal, yet still vote to remain in the Eurozone." - [xxii]

Epoch of Belief, Epoch of Incredulity (18): "Conspiracy Theorists" - [xxiii] suggested that the EU was plotting to allow Greece to default without officially "Grexiting". Schaeuble gave further credibility to this thesis last week, when he gave his support for a Greek referendum on Eurozone membership - [xxiv]. Schaeuble clearly has an ulterior motive; to fight the UK referendum with a Greek referendum that politically negates it. He would not have taken such a position, were he not in full knowledge of a plan to allow Greece to default and yet to remain in the Eurozone.

This thesis then received further support from an aide to Matteo Renzi, who opined that Greece will remain in the euro even if it fails to meet a debt payment - [xxv]. Having just paid the IMF, it would seem that Greece will default to the Eurogroup. It cannot default to the ECB, since this would spell a disaster for the Eurozone in general; a situation that Varoufakis clearly flagged when he opined that a Greek debt swap "filled (Draghi's) soul with fear" - [xxvi]. Far from being ostracised from the negotiations, Varoufakis is showing himself to be an intrinsic part of the "political" solution being hatched by the Europeans. In appearing to saturate the EU parade by his behaviour outside the tent, he is spiritually and operationally deep inside the tent. One wonders how he will be rewarded for his support in bringing about the very European solution. To get the full reward he needs to play his part with more subtlety, lest his Vaudeville show-boating gives the real game away.

Ewald Nowotny hinted that the Greek issue is viewed by the EU as "political" and not "economic"; thus hinting that the solution will be "political" - [xxvii]. A default to the ECB is "economic" as Varoufakis already explained; therefore the default must be to the Eurogroup, in order to trigger the specifically European "political" solution that they envisage. This European Solution was intimated already in Epoch of Belief, Epoch of Incredulity (19): "Inflated Expectations" by Jean-Claude Juncker; who has accused the "Anglo Saxons" of trying to derail the European Project - [xxviii].

The "Anglo Saxons" are allegedly trying to make a "political" issue out of an "economic" one, in order to destroy the Eurozone Project. They will thus be paid off and sent packing, or so the Europeans think. The "Anglo Saxons" will therefore get paid and then the Eurogroup will refinance all future Greek payments to them with a bailout of Greece.

George Osborne is no mug however. As the only Tory MP in the North of England, he knows the score and has a few more tricks up his sleeve; to work the magic of the "Northern Powerhouse" edifice that he has projected. As part of his cunning plan to deal with the EU and also advance his PM credentials, he signalled that the Queen's Speech will include further devolved powers to the great Northern cities - [xxix]. Osborne will therefore position himself, as a leader who is taking back power from Brussels and giving it back to the people of the North. It's pure genius.

Labour, whose traditional support comes from the North, will have no answer to this strategy; as it is itself a pro-European party by default. Even UKIP, the new number two party in the North, will be hard pressed to match Osborne's ingenious initiative.

Real Mancunians are overjoyed that Osborne's move will involve the professional Northerner Jim O'Neill moving back "Down South" to join the Treasury - [xxx]. He will therefore become a devolver of power rather than an accumulator of regional power; which can only be a good thing for the real people of the North. With Draghi at the ECB, O'Neill at Treasury and Carney at the Bank it's reassuring to know that there is still a corner of some foreign field that is forever Goldman Sachs. The odds on the firm positioning for and calling the Grexit and Brexit right must have shortened considerably.

The Bank of England therefore has to play the prudent role of counterbalancing all the incoming political and economic headwinds. With a majority, that will soon be bolstered by more of the UKIP faithful, the Tories can squeeze the last pips out of the public sector. A fiscal headwind must therefore be met with easy monetary policy from the Bank. The current unfolding Troika schism in Greece is positive for Sterling, therefore easy money can be maintained. How Sterling then performs during Osborne's flirtation with the Brexit, will depend upon what kind of damage has been done to the Euro by the current schism within the Troika. Governor Carney stated for the record that his job would be a lot easier if the referendum was held sooner rather than later - [xxxi].

As things stand today, the Troika schism is Euro negative and Sterling positive, so the Bank needs to err on the easy side with monetary policy. As a June rate hike from the Fed gets pushed back later in the year, Sterling is further underpinned. Given these externalities, it was therefore no surprise for the Bank to keep interest rates on hold last week - [xxxii]; and for Sterling to strengthen despite the low interest rate picture. This was then followed up by the Bank's latest growth and inflation projections - [xxxiii], which forecast much slower trajectories for both well out to 2017. Buried within the latest projects was a very disappointing forecast for productivity and investment. Falling productivity, which manifests itself in wage inflation that is passed on to consumers through price inflation, may yet force the Bank's hand - [xxxiv].

Despite the latent inflation pressure, Carney signalled that the impact of the Credit Crunch on economic growth remains more of a concern; that will make the trajectory of future rate increases shallow - [xxxv].

The biggest surprise of the week came from the BOJ governor. Mr Kuroda opined that all traces of slack in the economy are dissipating - [xxxvi]. He then followed up by saying that further QE is on hold for now, because inflation is picking up - [xxxvii]. Given that the Chicago Fed and Bank of England are keen to evince that there is ample space for growth in their respective economies, the question of how to play the Yen becomes more apposite. Taken at face value, all these "economists" are saying that Yen weakness is over. Can one trust an "economist" however after what has just been learned in this latest report?

Chart of Last Week has to be the one above. Corporate America is still deleveraging, but the process is flattening out. This means that it is now able to withstand the kind of spikes in interest rates that the Bond Sheep are currently creating. It also means that only a little leverage is required (and can be taken), onto corporate balance sheets, to create the kind of stellar ROE's and P/E ratios that a real equity bubble is made of. The rally in equities, thus far attributed to QE, could just as easily be attributed to companies getting their balance sheets and cash flows back into shape. It's all a matter of how one understands what one perceives.

The graph above signals mission accomplished on healthy balance sheets; so now it's time for aggressive American CEO's to start influencing their equity compensation by leveraging up. If this view is correct, the equity bubble hasn't even got started yet. For those readers old enough and stupid enough, to still be involved in the markets, things are back to where they were post Black Monday 1987 when our little journey began. The irrational exuberance and the leverage behind it just aren't here today. Fundamentally speaking, US equities offer value.

For those watching Exter's Inverted Pyramid the performance of Gold lately, shows that it's on green; signalling that a new wave of US private credit expansion is just about to take over from QE. Expectations discounted into asset prices, signal tighter Fed policy and higher interest rates however, which seems to conflict with the Gold signal.

The big names - [xxxviii] in the business are calling the End of Days.

The speculative net short position in equities is the highest it's been for a year - [xxxix]. Fed tightening has been well flagged and well discounted this time around, unlike the previous "Taper Tantrum" which prevented it from happening. The rumour has been sold therefore it now remains to buy the fact. Contrarians your time has come.

When an economist like Janet Yellen says that equity prices are "quite high", a little voice of reason in one's head says just buy 'em - [xl].

God Bless.

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