Age of Wisdom, Age of Foolishness (48)
Age of Wisdom, Age of Foolishness (47) “Black September – Red October” explained how the correction in global equity markets was being engineered by western central bankers, in order to lay the foundations for the next monetary and fiscal expansion. Age of Wisdom, Age of Foolishness (47) “Black September – Red October” also observed the chaos developing; as Algorithm Traders blindly followed the weak Yen is good for global equities algorithm which was then further blindly rationalised and accepted by the global-macro traders. At the beginning of last week, fundamental common sense started to prevail; as the Algorithm Traders flipped the switch and hence the fundamental consensus, to accept that a weak Yen is no longer good for global equities[i]. The global equity markets began to slide.
As the calendar switched months, consensus began to switch from the established beliefs which have underpinned the rally in equities. As soon as the consensus had switched however, the correction in American risk assets was over. Flows out of global risk back into the safety of the Dollar bloc put the floor under the American markets; which provides the base for a rally as the permanent expansion in the US money supply and wealth distribution get rolled out in the face of perceived global headwinds.
These flows were triggered by an innocuous press conference from Mario Drgahi last week. Draghi offered no new stimulus initiatives; and also took a big bite of German-cooked humble pie; when he strongly advised all Eurozone nations to adhere to the Stability Pact[ii]. France and Italy, who have been pushing to have this pact watered down, were immediately cut off at the knees; and their equity markets soon followed suit. The markets reacted as if he had tightened; when in fact all he had done was to delay the inevitable ease. Draghi understands that by being the humble central banker and staying out of politics, that the markets will deteriorate to such an extent that the politicians will have to accept his policies ultimately. Having taken Germany’s side over France and Italy, he is now owed a big favour by Weidmann, Schaeuble and Merkel.
Once the speculators understood that they had been doing Draghi’s work for him, the correction in European markets was over as swiftly as it began. As readers will find out later, the German economy has run out of liquidity also; so it is in no position to make austere demands on its neighbours. Europe is reaching an inflection point, at which monetary and fiscal expansion are about to be unleashed under a disguise of economic reform. Confirmation that the brief and swift correction had run its course was signalled as the US equity markets continued to rally and drag global markets with them; even as the September US Employment report suggested that the sell-off should continue, to reflect the accelerated timing of rate hikes from the Fed.
“…… and Endings”
The controversy surrounding the career of the “Bond God” Bill Gross was viewed as being symptomatic of this turning point. This controversy took another interesting twist last week, when it was announced that he will be going back to his roots as a humble “unconstrained” bond portfolio manager at Janus[iii].
Consensus on the weak Euro being a solution to the region’s economic growth problems has begun to change; so that now the weak Euro is no longer seen as a panacea[iv]. There will be those who conclude that a combination of fiscal stimulus and ECB QE will now be applied as the only possible solutions. Convincing the Germans to accept this, will however require the kind of negative price action which gets people talking about another recession that puts stresses on the unity of the Eurozone. This change in attitude to the Euro also correlates strongly with the changing attitude to the weak Yen; which now is beginning to accept that it is in fact a headwind rather than tailwind. The evidence from the latest Japanese inflation data suggests that, once the impact of the Sales Tax has been deducted, there has been no increase in inflation at the consumer level[v].
The falling Yen has therefore created a headwind through the higher price of commodity inputs, which have not been passed on. There will be those who believe that this signals a further drop in the Yen will be required to engineer this passing through of producer inflation to the consumer. There will also be those who see this final attempt to vindicate Abenomics as the opportunity to bail out of Japanese equities, before the last bulls have no more momentum buyers left to sell to. Japanese policy makers moved to accelerate the pace of the inflation pass through last week, by enacting legislation that will enable SME’s to pass on weak Yen induced commodity inflation to their customers[vi]. SME’s have now been given pricing power by the politicians.
As the inflation pass through is enabled to move faster, so the attendant economic headwind is accelerated also. To mitigate the rate of commodity inflation, policy makers are also now trying to decelerate the slide in the Yen; because its violence is becoming a destabilizing influence. Ex BOJ Governor Muto began to opine the case for a deceleration in the Yen’s rate of decay last week, just as the policy makers enacted the great inflation pass through from the SME’s.
“A Fundamental Bid for the US Dollar.”
The rising commodity inflation in Yen terms has another face in US Dollar terms which is deflationary. Consensus has therefore developed that US Dollar commodity deflation is pushing down US Dollar consumer inflation[vii]. The five-year real rate of return has therefore just gone positive[viii]; signalling that the consensus has become too aggressive on Fed tightening vis-a-vis the outlook for inflation. The Fed is therefore expected to counter this first by ending the Taper; and then cancelling the Tightening which is confidently expected to follow it. The positive real rate of return, puts a fundamental value bid in for the US Dollar and hence the US Treasury market.
“Loadsamoney …. For Now.”
The alpha of a new economic bloc, being created by the BRICS, which was first observed in Age of Wisdom, Age of Foolishness (37) “The Third Man(date)”[ix] has just encountered its first omega in Russian terms. President Putin’s intentions and capabilities to diversify away from and hence undermine the US Dollar have met a significant obstacle; in the fact that the size of the liquid bond markets of India, Brazil and China are much smaller than Russia’s US Dollar reserves[x].
“Another Bid for the US Dollar.”
President Putin may therefore be caught holding US Treasuries; just as their intrinsic value is diluted by the Fed’s boosting of the US money supply permanently. China by default, with its larger US Dollar reserve, is therefore caught in a similar but much larger trap. The logical conclusion would be to buy Gold; and there has been evidence in the physical market that this is going on, despite the fact that the paper Gold players are selling based on the strong US Dollar story. The paper Gold players, who sell it and then cash settle rather make delivery of Gold which they do not own, are therefore causing the price of physical Gold to look even more attractive to the BRIC currency bloc. Before he counts his riches however, Putin may need to reinstate capital controls; because his fellow countrymen are swiftly “diversifying” their hard currency as the country becomes even more isolated from already established capital markets[xi].
“The Thumbscrew Torture ….Before the (Printing) Press.”
The Fed has been tightening capital adequacy, on the banks in its regulatory jurisdiction, more than regulators in any other global location. This has the negative economic impact of making credit more expensive to borrowers; and more restricted by banks who do not wish to pay the higher capital surcharges to make riskier loans. The UK’s Financial Stability Board (FSB) got in on the act; and increased the cost and decreased the supply of credit last week. Banks in the London regulation zone must now increase their level of capital; in what is known as “total loss absorbing capacity”. Riskier lending will now require more capital, either issued as equity or some other form of contingent debt liability, related to the loans being made. Credit created in any currency, in the London time zone, will therefore be less abundant and more expensive for borrowers. The FSB has therefore tightened monetary policy without involving any global central bank monetary policy committee.
This move reflects the emergence of the newly created Financial Stability Panel over at the Fed. It must now be concluded, with a little more certainty, that the Financial Stability groups within the respective central banks rather than their monetary policy making boards are now in control of Anglo-Saxon monetary policy. The ECB and BOJ have thus far avoided this trend towards Financial Stability policy making bodies; however this trend is part of the emerging thought school which is now in control of central banking. It is therefore only a matter of time, before this policy is adopted across the major global central banks. A financial crisis in the meantime, will only speed up this adoption. Speculators have so far failed to discount the macroprudential tightening of global monetary policy, emanating from Washington and London; and have instead focused on perceived looser monetary policy from the ECB and BOJ.
“Slippers on the Ground to Launch the Pirouette.”
America’s Pivot to Asia has been frustrated by the deterioration of the Middle East situation. America has however been able to keep the Pivot alive, by attempting to keep its “boots” off the ground; and have them replaced with “regional boots” instead. Last week, signals emerged that America may in fact be able to “Pirouette” to Asia via the Middle East after all; so that China is effectively contained from both the east and west. The “Pirouette” involves spinning on “regional boots on the ground” rather American. Asian public opinion is now being framed to accept the same threats, as those in Europe and America, from the returning Jihadi veterans of ISIS[xii]. President Obama continued to verbally “Pirouette”, via the Middle East, when he blamed this strategic manoeuvre on the deficiencies in his intelligence services in underestimating the threat from IS[xiii]. This story seems oddly reminiscent of the oversight of significant Russian forces, on the borders of Crimea and Ukraine, earlier this year. One of something is a coincidence; but two of the same thing suggests a pattern. America’s national security infrastructure would seem to be doing a very poor job of observing and responding to global threats.
America apparently now has no option, other than to engage IS in a more robust manner, because this oversight has allowed IS to grow into something of strategic significance. An objective observer may have noted that the closing of Guantanamo Bay, by the President, meant that there was suddenly no place to “contain” the same individuals who are now being “contained” in Syria and Iraq. Once again, two of the same thing suggests a pattern. The same observer may also have noted the curious similarity in dress code for the prisoners at Guantanamo and the prisoners of IS. This similarity in dress code can surely be no coincidence; and seems to support the notion that yesterday’s Guantanamo detainees are today’s gaolers. Once again, two of the same thing suggests a pattern.
With these patterns developing, one therefore senses that an Islamic State In Asia (ISIA) acronym is about to join the lexicon of terror. This event will ultimately have the effect of increasing Asian support for the current campaign in Syria and Iraq. As the threats move east into Asia, America will then be called upon by its Asian trade partners for assistance. The “Pirouette” therefore has an external dynamic to keep it moving from the Middle East to Asia. The mystery, surrounding Malaysian Airlines MH 370, thus far remains unsolved; therefore there remains scope for it to re-join the narrative. The “Pirouette” is also US Dollar positive.
“Same Thumbscrew, Asian Fingers.”
This stronger US Dollar story, which is bad for Asia, is already being anticipated by some Asian nations. South Korea, for example, last week began its own form of contagion risk management; by opining that currency outflows back to the US Dollar need not be as destabilizing as they have been in the past. It is not averse to currency depreciation however, so long as it is not violent; and as long as it brings back export competitiveness with the Yen. Smoke signals about a devaluation, were sent out last week; to test the currency market’s acceptance in principle[xiv]. South Korea clearly suspects a confluence of events, similar to those which precipitated the Asian Crisis of 1998, occurring again. If such an event occurred, the epicentre of the crisis this time would be China. Thus far, cosmetic policy moves to stimulate the Chinese economy have been unsuccessful; mainly because China’s interest rates have been liberalised to such a degree that the PBOC can no longer act as the invisible hand. The invisible hand is now in the hands of global capital markets. China therefore has effectively lost control of its economy; just at the moment that America is “Pirouetting” and Pivoting towards it, from both the Middle East and South China Sea, on the back of a stronger US Dollar.
Age of Wisdom, Age of Foolishness (47) “Black September – Red October” observed Israel’s attempts to destroy Ayatollah Khamenei’s “New World Order” vision; in which Iran plays a major role. If America is now “Pirouetting” through the Middle East towards China, Iran becomes the axis. Some form of direct engagement between America and Iran is therefore necessary. Thus far the engagement has been informal and mutually supportive, because of the mutual threat from IS. If and when IS is taken out, the nature of the relationship by default therefore changes; because the mutual threat is gone. America will also be well into the next phase of its own Presidential cycle by then; which may then create a totally different perspective on relations with Iran. Israel is already looking at this future point, rather than the current one which is defined by IS. Last week, Prime Minister Netanyahu sought to focus America and Europe more closely on this future outcome at the UN[xv]. President Obama tried to remain aloof by criticising Israel’s settlement expansion policy[xvi]; which undermines America’s ability to find willing “regional proxies” to fight IS. His criticism also aligns him with Iranian interest.
“Same Thumbscrew, European (and Japanese) Fingers.”
Age of Wisdom, Age of Foolishness (47) “Black September – Red October” observed a new consensus developing in the major currencies that had weakened versus the US Dollar, namely the Yen and the Euro. The new consensus being formed is one that now believes that currency weakening versus the US Dollar is not working in the traditional manner of stimulating exports and economic growth.
“EM Carry Trade Tipping Point.”
It is now feared that the “Carry Trade” in Emerging Markets will get unwound violently by the stronger US Dollar[xviii]. Currency weakening actually drives investment capital flows towards America; which further undermines the devaluing economies by depriving them of investment led growth. This phenomenon has been experienced in the Emerging Markets, throughout the Fed’s Tapering period.
In the Eurozone, capital initially fled to Germany; which therefore experienced the stimulus from these flows which were able to prolong its growth cycle. The recent signs over the summer, especially after the crisis with Russia, suggest that capital is now leaving Germany and heading to America. American investors, lacking this global perspective, will therefore not appreciate that there is a huge bid underneath their markets, which will prevent the precipitous sell-off anticipated by the Fed tightening.
As occurred during the “Taper Tantrum” period, when capital left Emerging Markets, the American markets did relatively well. This time around, capital is leaving China, Russia, Europe and Japan; in addition to the Emerging Markets. The bid for American assets will be spectacular.
With this in mind, the Fed is presumably not so worried about the value of its balance sheet; especially given that it has no intention of selling into this wall of money heading America’s way in any case. This wall of money will just support the value of the Fed’s balance sheet; so that it doesn’t have any embarrassing mark-to-market losses, which will get closely scrutinised by Congress.
The real problem comes, when the foreign holders of all these US Dollars smell a new wall of them being created by the Fed and the Treasury. At this point, they will dump their Dollars for Gold, if nothing more profitable can be found to invest in at home. Alternatively, they will use all their Dollars as collateral to create more of their own currencies to kick start their own economies; which seems much more likely.
Beggar Thy Neighbour Tightening
“That was another fine mess Stanley.”
Stanley Fischer knows all about this, because his first job on becoming Vice Chair was to sell the idea that Fed tightenings are actually good for global stability[xix]. It’s interesting to see him back in control of the Fed’s new Financial Stability Panel therefore, just when this event reappears. His comments on the same subject, this time around, should be interesting.
His hope is that the next crisis in the markets will allow the Fed to assume the “Third Mandate”[xx] to regulate economic activity by controlling asset prices. This will allow the Fed’s balance sheet to remain permanently expanded with whatever assets it is seeking to control the price of; and hence influence the specific sector of the economy related to these assets. Steve Schwarzman of Blackstone fully understands where this is going; as the banking system gets disintermediated by the Fed so that it is nothing more than a transition mechanism for Fed policy control.
The Basel III rules actually enhance this process of disintermediation; by giving the Fed the competitive advantage in balance sheet scale. Commercial banks require expensive capital to expand their balance sheets, whereas the Fed has no limits other than those set by the benign inflation and growth data.
The commercial banks’ money making franchise is over; and Schwarzman is very unhappy about this. He therefore began his crusade to fight back, against this move to disintermediate Wall Street, with a speech in Dubai; which opined that Basel III was shrinking the banking system and creating a global recession[xxi]. Schwarzman versus Fischer is going to be one of the more interesting grudge matches to watch going forward.
Germany’s growth cycle has now ended; and once this is accepted by the Bundesbank, growth solutions will be forthcoming. Since fiscal stimulus and deficit monetization are however Verboten; the transition to a stimulus phase will be egregiously slow and awkward. During this transition phase, the weaker economies in Europe (including France) will be pushed to the limit of their continued membership of the bloc.
Last week the commentary started to directly compare and contrast Japan with the Eurozone[xxii]. Both have weakening currencies, both have aging demographics and stagnating economies; in addition to budget deficit problems. Both have tried to devalue their way back to growth, in order to pay down their debts; and both now seem to be failing in this endeavour. Japan has however broken the symmetry; by starting another round of fiscal expansion, disguised as a temporary short-term fiscal boost to overcome the headwind of the Sales Tax rise. Southern Europe would like to do the same thing; but Germany holds the purse strings and is still committed to economic reforms.
The Eurozone therefore has no fiscal primer in place; and will therefore weaken more than Japan in the short-term. Observers are assuming that the ECB will ultimately get its way on QE, just at the BOJ did. The Eurozone is therefore like Japan, however it has a significant policy lag. Where Japan is today, the Eurozone will be tomorrow. Today Japan is acknowledged as being on the threshold of another recession[xxiii]; so this is where the Eurozone will be in very short order.
“The Wolf of Downing Street.”
Age of Wisdom, Age of Foolishness (47)“Black September – Red October” analysed the position of events in the UK; as the inflection point at which the global equity market correction set in. The apparently charmed life its opportunistic Chancellor is living, as he positions himself to move homes from Number 11 to Number 10 Downing Street when the hapless Prime Minister is turned upon by his own party and the electorate, was also observed. Looks can be deceiving however.
“The Prestige is Wearing a Bit Thin.”
Key Signals’ intelligence customers are familiar with what is known as the “Prestige”. It is customary in British Politics, for the standing government of the day to gamble with the nation’s finances; by making rash promises in order to get re-elected. New Labour left the Coalition in the financial hole. In order to get out of this hole and to create some kind of fiscal surplus, with which to gamble in the same way running into the next election, Chancellor Osborne devised a perpetual motion machine.
By creating two measures of inflation, he was able to arbitrage the government’s receipts and payments. The lower measure RPIj was used to index the government’s liabilities. The higher RPIx was used to index its tax receivables. The spread between the two was therefore supposed to reduce the deficit and create a kitty, to be used for attracting votes with fiscal largesse during the next election.
Mark Carney was hired to apply QE in order to start the machine. Unfortunately the economic recovery has been weak, in terms of tax receivables, because companies have also adopted the same strategy as the government; so that wages and the prices of goods and services have been cut rather than raised. The weak growth and disinflation have therefore not yielded the higher tax receivables indexed to the RPIx. Osborne has therefore had to revise upward the fiscal deficit[xxiv]. There is thus no kitty to tactically deploy to gain votes in the next election.
Faced with no slush fund to attract votes, David Cameron has therefore gone for the New Labour tactic of cutting cheques and making promises that the taxpayer cannot honour in the next parliament. He has promised to maintain the NHS budget in real terms[xxv]; and also raised the lower and higher thresholds on income taxes[xxvi]. Applying Osborne’s RPIx and RPIj “Prestige”; there will therefore be significantly more going out than coming into the UK exchequer after the promises are honoured.
“Get a Life.”
Osborne has been more cute. Evincing a fiscally neutral and hence prudent stance, he has cut welfare[xxvii] spending in order to fund the abolishment of the “death tax” on pensions[xxviii]. With an eye on number 10 (and also on UKIP) he is therefore politically favouring the pensioners, over the less fortunate who would presumably vote Labour in any case. Considering that the Scots were bought off with future hypothecated tax revenues, during the referendum on UK membership, the UK’s deficit will balloon even further if the Conservatives are re-elected with or without Cameron as PM. Should the provinces demand a similar fiscal bribe and fiscal autonomy as the Scots, the misery for the taxpayer will just compound further.
Just to underline the fact, that Scotland was the global alpha and omega point, Osborne murdered a cheeky but inappropriate quote from the film Trainspotting about “choosing life”; which was swiftly rebuked by the author[xxix]. The good news for Britons is that they will be able to calculate and pay for all this in Imperial currency units; since Cameron signalled that he would like a return to Imperial Units[xxx] as Britain pulls away from the Eurozone and goes back to empire building. The next government will then have to print these new Farthings, Shillings and Pounds etc.; in order to inflate its way out the debts that Cameron and Osborne have offered to today’s voters, who have forgotten that they are tomorrow’s taxpayers.
The Bank of England is clearly scared to death. Kristin Forbes opined equivocally that on the one hand the stronger Pound had held inflation in check; but on the other hand now that the period of Pound strength was over inflationary pressures will appear[xxxi]. The Bank can’t raise interest rates prematurely because the economy is too weak. Faced with the fiscal and political consequences of a potentially hung parliament of some kind, which inherits Osborne’s unbalanced legacy, the Pound is facing a major hurdle. Throw in the potential for the “Brexit” and it looks even worse for the Pound.
If speculators see through the equivocal guidance and ask the Bank to act against an inflationary risk and a currency slide, then the hikes in interest rates will just lead to an even weaker economy and hence an even weaker Pound. Speculators are seeing 1987 all over again in global equities, but in the UK’s case they should throw in the 1992 EMU exit also.