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posted on 26 August 2015

Epoch of Belief, Epoch of Incredulity (31): Collateral Damage

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The fallout discussed in Epoch of Belief, Epoch of Incredulity (30) "Blowback" continued last week.Jean Claude-Juncker widened the divide between the EU and Germany, whilst seeking to cling to his job, by stating that the "Grexit" would be off the table if Greece delivered on its promised reforms.

Having seen that the IMF now offers potentially better terms, after the Saltwater faction took controls of its communications and opined that debt restructuring beyond debt maturity extensions is the only solution, the Greeks promptly ditched the idea of an exclusively European solution and applied to the IMF for help. The IMF and the Saltwater faction within it is now thoroughly embedded at the heart of negotiations with Greece again.

Sensing this change in dynamics, Jens Weidmann softened the tone of German rhetoric; and aligned it more closely with the IMF's position. According to his latest reckoning, a three year debt extension can be offered to Greece if it applies for an European Stability Mechanism (ESM) bailout package. He made it clear however that, notwithstanding this potential three year extension, any extension has come too late to materially benefit the Greeks. Weidmann is thus playing along with the IMF, whilst making it clear that there is a three year window during which the Grexit remains an option. The IMF is on record as saying that extend and pretend does not work; so now both Weidmann and the IMF have some common ground to maintain a civilised dialogue and address the taboo subject of a debt haircut.

One suspects that Weidmann would actually like a debt haircut, despite what he says, since this creates the need for an ECB recapitalization event; at which point the Bundesbank can increase its ownership and control Draghi's wayward money printing vehicle. Wolfgang Schaeuble completed the other move, of the German pincer movement, by embracing the French proposals for deeper European integration. Schaeuble signalled that Germany is willing to engage, in dialogue that will lead to a sharing of its fiscal revenues with a central Eurozone treasury mechanism. He was then swift to qualify his position, by demanding that the European Commission relinquish some of its oversight and governance powers.

It is thus clear that Schaeuble intends to keep a very tight control of just how much political power Jean Claude-Juncker can abrogate for the undemocratic Commission. Going forward, it is clear that the Commission's structure and mandate will be made subject to a democratic voting process throughout member nations. Without this democratization, the European Project will have no legitimacy or future. The European Commission will therefore be the battle ground, over which the two major voters France and Germany fight for control of Europe. Re-elected Eurogroup head Jeroen Dijsselbloem has already tabled Schaeuble's proposals for the democratization of the Commission onto the 2016 agenda.

Schaeuble's advance to contact falls well short of direct engagement with Hollande's demands for a single Eurozone government, as the Phoenix to rise out of the ashes of Greece. Schaeuble therefore follows strict protocols and discipline, leaving the issue of political integration to Merkel. Clearly the sharing of German tax revenues will be conditional upon all member nations adhering to Stability Pact principles in relation to their fiscal deficits. This fact was underlined by CDU proposals in the German parliament to force private lenders to absorb any national default by an EU member state.

Italy, a nation often cited by Eurozone bulls as being the beneficiary of adopted Stability Pact discipline, showed that there is still wide divergence in economic performance which vitiates against deeper fiscal integration. Italian labour force participation continues to plummet, even as the Italian economy shows great economic advances, as Italians join the ranks of the long term unemployed. Unemployment and social security payments, to this swelling rank of the unemployed, will therefore clash head on with Stability Pact enforced fiscal discipline very soon. This alarming picture provided by Italy, is apparently representative of the Eurozone in general; and has prompted the IMF to release another gloomy picture of the growth prospects there. Notwithstanding the ECB's monetary stimulus, the IMF still calls for major structural reforms in order to capitalize on this growth headwind.

It has been suggested that Christine Lagarde's position is under threat, after her initial mistake of aligning with the Freshwater faction within the IMF that wished to enforce tough austerity terms onto the Greeks. Further evidence of her demise was provided by her Deputy, David Lipton; who opined that the next Managing Director will be appointed on merit and will not necessarily be a European.

Lagarde has said that she will seek a second term if she receives common support from IMF members. This support now seems to be conditional upon her delivering the desired American solution for the next Greek bailout. In relation to the third Greek bailout talks, the IMF threw a spanner into the works by stating that it will not get involved in another bailout unless there is a clear statement from the EU on its intentions and capabilities to relieve the Greek debt burden in addition to a reciprocal commitment from the Greeks to enact economic reforms.

Tsipras, after fully aligning with the Troika's terms, now faces political skirmishes all the way into September over the Greek's willingness to accept new bailout terms and to reciprocate with economic reforms. A vote of confidence (or not) will no doubt be required to formalize the Greek position, at which point new elections are bound to ensue as the Greeks continue to try and dodge the bullet on austerity and reform. New elections will then be framed as yet another referendum on Eurozone membership. None of this however matters for the Euro or the markets any more, as the effects of the Taper Tantrum have seized the limited attention span of speculators.

Blowback from the Fed's Taper Tantrum got stronger last week. Last week's FOMC meeting was all about the potential for a September interest rate hike, so attention was focused on any signal for this widely anticipated upcoming event. As it happened, trader attention was even more focused on the second rate hike rather than the first; suggesting that there are some who are keen to fully discount the whole tightening cycle and get back to anticipating the next round of monetary easing.

The Gallup consumer confidence data, on the eve of the FOMC meeting, suggested that even September is looking premature for interest rate lift-off. American consumer confidence peaked in January, when Mario Draghi was doing whatever it took in the face of deflation. It is now at a 10-month low and headed lower.

The latest GDP release came in at the lower end of expectations, suggesting that the US economy was already decelerating in Q2. Unfortunately for the Fed, the deceleration is not significant enough to put the beginning of the rate hike cycle on hold. Core inflation also hit its 2% target, giving even less room to stall the rate hike cycle. The Fed is therefore now committed to tighten monetary policy, into a domestic economy that is decelerating and a global economy that has accelerated its contraction.

Fedwatchers must also begin to factor in the changing of the guard at the Fed. President Obama has squeezed Kathryn Dominguez into the deck of Governors; so it can be assumed that she is of the Dovish pro-growth persuasion. Outgoing Hawk Charles Plosser has just been replaced by Patrick T. Harker. The Texan Hawk Fisher has yet to be replaced, as has the outgoing Dove Kockerlakota.

When the Old Guard was leaving, accelerating growth and inflation framed the debate on the FOMC. In the recent past, Greece and China have popped up on the radar screen; and global growth has begun to lose momentum also. It is therefore abundantly clear that, despite the "Dot-Plot" from the FOMC, consensus within the Fed itself is anything but firm. There is talk about the first rate hike, but the Fed still remains data dependent. Bond Bears, Gold Bears and Dollar Bulls, who take all this for granted, will be forced to revisit and retest their assumptions and convictions very shortly.

TIPS traders are already betting the ranch on lower inflation, which suggests that the Fed's expected tightening trajectory will be shallower and shorter in duration.

Epoch of Belief, Epoch of Incredulity (30) "Blowback" examined the peculiar preparations for future monetary easing being made by the BOJ, against the backdrop of the Fed's Taper tantrum and its negative impact on the Yen. The anxiety shown by Japanese policy makers resonates strongly in South Korea also. BOK board member Moon Woo Sik, followed Japanese precedent and suggested that the inflation target should be lowered to 2% from 2.5%. A lower target will take the pressure off the BOK to do more easing, in the face of Fed rate hikes which will compound the destruction of the Won. Clearly, emerging market central bankers are now more worried about capital flight, sucking liquidity out of their economies, than the positive impacts on exports from lower currencies. The situation has also become a source of immediate worry for the BOJ.

Last week rumours began to emanate from Japan, suggesting that Kuroda had not intended to end the decline of the Yen against the US Dollar prematurely with his comments. These rumours have come too late however; and now Kuroda's real intentions and capabilities will be tested, in relation to the Yen, by speculators driving it higher to see where his real "fault line" is.

The conundrum facing the PBoC, of whether to weaken the Yuan to stimulate growth but then to risk greater capital flight versus strengthening it to gain entry to the SDR basket, perfectly illustrates the dilemma. The political dimension of China's dilemmas is becoming evident in the price action in its capital markets. Capital flows to companies which are viewed as deserving of strategic cash injections from the government. Real private companies are being avoided by investors, primarily because they are viewed as corrupt and lacking in corporate governance.

The bizarre situation has arrived in which Xi Jinping's initiative to privatize the state controlled economy and allow markets to ration capital has totally failed.

Private capital now only flows to companies which have government related corporate governance structures in place; in addition to the obvious implied moral hazard government bailout floor underpinning their balance sheets. Facing this failure, attempts are being made to make it appear like a success at the next (Fifth) Plenum in October. It has already been leaked that the State Owned Enterprise (SOE) sector and its reform will be addressed at this Plenum.

The knee jerk reaction to the equity sell-off, by policy makers, has created a bubble in SOE valuations; that can only be sustained as long as the government props them up. The government must now decide on whom to save and how much money is available to try and save them. Clearly there is not enough money to save them all, without destroying the country's reserves.

An American economy, which is sliding back into deflation, sucking in liquidity from other capital markets is simply a transmission mechanism for global deflation. This is the true agency of the Taper Tantrum. Those who think that Gold is falling because the Fed is tightening are right for the wrong reason. They are also in a very crowded short trade, that is about to inflict the kind of carnage on the crowd that the big sell-off in Bonds did earlier in the year. If the crowd is also in the short Bonds trade, the pain will be excruciating.

Gold recently broke down because inflation is low (and falling); and also because central banks are afraid to go all-in to prevent inflation from falling further.

When the central banks change their minds and their rhetoric, the snap back in Gold will be violent. They must however all wait for the Fed to admit that it is wrong about tightening. The Fed now has to decide if it wishes to (a) lose face by calling off rate hikes, or (b) lose face by hiking rates and then having to reverse them when the global economy nosedives further.

Epoch of Belief, Epoch of Incredulity (24) "The Magnificent G-Seven" suggested that Britain and America would use the platform of political and corporate governance best practice to promote their global agendas. Confirmation of this was provided by both leaders last week, when Cameron said that London's property market was now officially closed to money launderers and President Obama had a go at his forebears about corruption.

Rupert Murdoch however reminded both "Political Governors" of the blowback and risks of hypocrisy inherent in their strategies, with the revelations that the Lords' custodian of political governance standards was in breach of them. It is interesting to observe that Murdoch has been lionised for disrobing the wayward Lord Sewell, in comparison to his own demonization for tapping the phones of celebrities. The invasion of privacy in England is therefore acceptable under mitigating circumstances when it follows the new wave of political correctness.

Hatred, of the ruling classes in Britain, is also still clearly running way ahead of envy of the rich and famous, which is quite a statistic given the favourite British blood-sport of celebrity bashing. The masses must therefore continue to be thrown a juicy sacrificial bone, every now and again, to prevent them from gnawing on the political leadership.

Some of our readers are steadfastly holding out against accepting the fact that Rupert Murdoch has played any part in the events attributed to him in these commentaries. They would be advised to follow the line of questioning, currently being adopted by what remains of the Labour Party, in relation to the lengthy conversations between Murdoch and George Osborne, leading up to the dumping of the burden for financing the over-75's TV licence fee on Auntie Beeb. They may then find the subtle aroma of a payback for services rendered. Murdoch has much to gain from the revenge attack on the BBC being led by David Cameron and Osborne.

David Cameron led the civilised world in the fight against Islamic Radicalization last week, on his tour of Asia. What he calls the "common enemy" is now under attack. What did not get as much headline coverage was the related fact that George Osborne was doing his bit for said radicalization with his spending cuts. The axe of spending cuts falls hardest on the ethnic minorities who will then become the "common enemy" by taking up the sword of Islamic Radicalization as a pecuniary consequence of fiscal austerity

When Cameron therefore opines that this struggle between good and evil is a multi-generational battle, he is speaking with the full knowledge of someone who is perpetuating said struggle over the generations as a matter of policy. The ethnic majority, that will also feel Osborne's axe, will therefore be sufficiently distracted by the problems created by the ethnic minority so that any political blowback reserved for Osborne and Cameron will be fully directed at the said radicalised "common enemy" rather than the "common fiscal enemies".

Osborne followed up on Cameron's initiative to renegotiate the Eurozone treaty last week. Wolfgang Schaeuble's shifting position on a common Eurozone treasury, should have signalled to him that the aligned interest with Germany, to enforce economic reform, is running into trouble. Schaeuble's position on reform is based primarily on the German commitment to Europe through the Stability Pact principles.

Cameron's position is based on the subsidiarity of the Eurozone policy to national parliaments.

The two positions seem to be incongruent under current circumstances. Osborne will find no support in Germany, unless he can offer continued British support for a common European treasury; a dog that currently doesn't hunt in the country where Cameron is bringing back fox-hunting. To illustrate that he was walking into a trap, Emmanuelle Macron made it clear that there was no way that the European Treaty could be changed at this point in time, given what is going on within the Eurozone.

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