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posted on 16 September 2015

Epoch of Belief, Epoch of Incredulity (33): Beggaring thy Neighbors' Beliefs

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Epoch of Belief, Epoch of Incredulity (32) "Semantic Webs" suggested that the convictions underlying the markets' most crowded trades were going to be tested going forward. This process began in earnest in recent weeks. In the Eurozone, the Troika and Greek negotiators reached a deal in principle over the terms of the next bailout deal - [i]. These terms will now endure a trial by fire, on the streets in Athens and in the German parliament - [ii], as they are forced through. The Germans should be happy, the Greeks less so, since the terms of the new deal virtually cede total political and economic control to the EU - [iii].

As the deal attempts to go through in practice and the Eurozone continues to show growth alongside economic reform, the case against the Euro gets tested. The recalcitrant Finns auspiciously gave the new deal breakthrough the thumbs up; suggesting that the "Europhoria" has some legs - [iv].

Expectations should however be reigned-in, since relations between the EU and the IMF remain as strained as ever. The EU moved its position to support the IMF's conclusion that Greek debt is unsustainable; only to then abandon the IMF's proscriptive solutions to address this problem. The IMF still holds the opinion that a debt write-down is the only true solution. The option for direct EU wealth transfers to Greece would also meet with IMF approval. A Greek debt extension would only be considered if it had a meaningful 30 year maturity. None of the proscriptions seems to suit the EU; or rather its Northern European contingent. It can thus be seen that, behind the platitudes on both sides, the IMF and the German core of the EU are still diametrically opposed - [v].

Testing the convictions in the Fed's expected tightening cycle is also getting more convoluted these days. The problem is made worse by the fact that the Fed has a dual mandate; and the economic data is equivocal. Speculators don't have an equivalent dual mandate; and are apt to succumb to bias. There is enough growth data and Fed guidance to support the speculation on imminent tightening; whilst there is also enough slowing growth data and falling inflation for those on the other side of the trade to try their hand. Kit Jukes neatly described the unfolding war of attrition, between both sides of the debate, as their convictions get tested - [vi].

Just to muddy the waters further, Stanley Fischer appeared to glacially move away from his Dovish side of the neutral divide, towards the Hawkish one, when he opined that the current deflationary situation is temporary - [vii]. He was then balanced out by uber-Dove Bill Dudley, who opined that September is not necessarily the lift-off date for rate increases - [viii].

The real dog that has not been barking is the Fed's Labour Market Conditions Index (LMCI), much heralded when it was introduced but long since forgotten. This alleged panacea indicator, which was introduced last October when the data supported the case for early tightening, has been largely forgotten since its genesis - some suggest because it no longer supports the case for tightening. The LMCI plummeted again last week and as it did, so did its utility as an index to support the Fed's tightening bias. It may actually prove to be the canary in the coal mine that signals an oncoming recession - [ix].

Epoch of Belief, Epoch of Incredulity (31) "Semantic Webs" observed the subtle change in semantics of Bank of England MPC communications, framing perceptions of the timing and trajectory of interest rate increase expectations; in order to postpone the lift-off date and reduce the incremental tightening profile. Like the US, the UK credit cycle is peaking; just as the Bank of England is considering tightening.

As the quiet period surrounding the MPC meeting ended, the rhetoric became stronger. Mark Carney signalled that British consumers are still carrying too much property debt, to take the strain of large increases in borrowing costs - [x]. What he was implying is that there is a new property debt bubble, that he has no intention of bursting. Ben Broadbent also chimed in that there is no rush to raise rates - [xi].

As George Osborne applies more fiscal austerity, the burden of driving growth will fall more heavily upon the indebted consumer; therefore Mark Carney will try not to overburden him/her with punitive rates of interest. The latest unemployment data for Q2 showed that unemployment rose as wage growth slowed, further underlining the MPC's caution. The 8-1 MPC vote to keep rates unchanged, in the previous week, was taken by some observers as confirmation of a consensus view on the holding off on rate hikes.

Last week, David Miles gave the first signals that this consensus was not as widely held as had been previously assumed - [xii]. According to his recollection of the MPC decision, there was significant debate over the case for raising interest rates. It looks as though Carney and those loyal to him have gone out on a limb again. Careful to cover his tracks, after sticking the knife in, Miles retreated behind a disclaimer comment that the emphasis is on the gradual nature of future interest rate increases - [xiii].

Chinese policy makers exploited the volatile hiatus in order to seize back the initiative from their American tormentor, which speculative convictions were being tested. American control of the IMF has thus far thwarted all Chinese attempts to join the SDR basket. The Chinese had therefore been pinned down, into pegging their exchange rate to the US Dollar; at a level that neither chokes off capital flight nor stimulates inward investment. Always keen to use their asymmetric warfare capabilities, the Chinese executed an entirely unexpected policy move that seized back the initiative a few weeks ago week by devaluing unilaterally without warning - [xiv]. This was followed by a weak commitment from the PBOC to stem excessive volatility in the currency's downward adjustment - [xv].

The net result was equivalent to a Fed tightening; and now gives Chinese exporters a much needed leg up on their global competitors. It also gives the FOMC further pause for reflection on tightening. The Chinese have learned from the efficacy of the BOJ's unilateral move to weaken the Yen; and have followed suit. Now there will be a wave of tit for tat competitive devaluations, rippling across Asia, to eventually hit the developed economies head on.

The fear and loathing of the Taper Tantrum in emerging economies and their asset prices, currently being discounted, has suddenly been overtaken by a new wave of speculation on where the impact of competitive devaluations will fall next. A race to the bottom, started by China and ending with the Fed, has therefore become the frame through which trading activity is now referenced.

The baton of global central bank easing, originally passed from the Fed to the BOE and BOJ and then to the ECB, has now been snatched by the Chinese. Totally wrong-footed and lost for words, the best that the IMF could come up with was a cautious welcome to China's allowing the markets determine its exchange rate - [xvi]. The emerging consensus in the markets is that the Chinese devaluation will spread deflation throughout the global economy - [xvii]. In consequence, early movers are using the dip in risk assets to buy - in anticipation of the premature ending of the global central bank tightening cycle, followed by a new easing cycle to fight the emerging deflationary headwinds.

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