Since making its appearance in the last report, entitled "Synthesizing QE Thesis And Fiscal Policy Antithesis Into A New Global Pyramid Scheme", the operative word seems to have become "transition".
The last report noted the Eurozone in "transition" from Jean- Claude Juncker's call to arms in defence of the disintegrating Eurozone and its currency. His call came as the re-emergence of national border controls put the Eurozone's core principle of freedom of movement to the test. Juncker's nemesis Jeroen Dijsselbloem, a man who trusts Northern European elected parliaments more than Juncker's unelected European Commission, used this threat to the Commission as an opportunity for his Eurogroup to gain the initiative.
Under Dijsselbloem's plan, a new mini-Schengen Zone comprised of the trusted nations of Sweden, Austria, Belgium and Germany may need to be formed. This new "Core European" gang of four could loosely be called "Teutonic Europe". Its formation therefore implies the creation of a parallel economic and political zone in which the Euro is used. By logical extension, other nations will then have to apply to join it; although the official criteria for membership as yet remain unknown.
In an uncharacteristic conciliatory tone, Dijsselbloem then nudged his adversary Jean-Claude Juncker towards his own baseline on European fiscal and political integration. Juncker's opened the gambit, on deeper integration, when he outlined a proposal for the mutualisation of bank deposit insurance risk. Dijsselbloem embraced this concept and then undermined it in practical terms, by saying that a "transitional" phase would be required until the ultimate mutualisation in 2024. No doubt this "transition" will be by way of "Teutonic Europe" or will use a "transition" vehicle that broadly resembles it.
Building on Dijsselbloem's platform, Angela Merkel extended membership of the "Teutonic Zone" to the nine nations who have accepted the most immigrants from Syria. The "Teutonic Zone" therefore has both economic and political drivers of unification, based on current conditions. So coherent are these forces that the nine members held their own mini summit on the crisis in Syria separately from the official summit on the subject being hosted by Turkey. This group will now serve as a platform to drive foreign policy. Its first tactical political step will be the fast tracking of an immigration deal with Turkey. This will then serve as the platform for the creation of all foreign policy for the new Eurozone. As the wider Eurozone disintegrates, there is therefore a substitute ready to take its place.
The last report also noted how Germany has publicly fallen out with the ECB, over Draghi's telegraphed expansion of QE. Going forward, it will be instructive to look for a meaningful alignment of interest and purpose, between Dijsselbloem's putative "Teutonic Europe" and the breakaway German faction within the ECB. The emergence of these two alternative Eurozone initiatives cannot be viewed as either coincidence or serendipity since Germany is the common denominator in both. The battle for the Eurozone of the future's construction, in addition to the hearts and minds of its people, are therefore in full swing.
The horror of a collapse of the Eurozone and its currency, in "transition" via the agency of Schengen Zone disintegration, has been notably identified at the ECB. In the last report it was also observed that Mario Draghi prefers not to directly opine the threat to growth from terrorism and immigration, whilst leaving this distinctly more political rhetoric to his colleagues. This division of responsibility was evident in the latest ECB minutes and Draghi's press conference. Draghi chose to focus on the lack of inflation and the window of opportunity that this created for a policy move on December 3rd. In contrast, the latest minutes showed that his colleagues strongly debated the geopolitical headwinds from terror and immigration at their last meeting.
Governing Council member Ignazio Visco, in comparison with Draghi, was far more animated in his criticism of the politicians. His criticism is based on their inability to understand the grave consequences of their failure to coordinate and integrate more closely. He lambasted the politicians by saying that "we must make this economic and monetary union more complete: the problem is not only that of successions of monetary, banking, capital and fiscal unions, I believe the underlying problem is a lack of political vision".
Following all the hype around the well telegraphed signal, about the expansion of QE, the event itself was an ant-climax. The modest moves by the ECB, intended to signal a measured but meaningful commitment to address deflation risk in the long-term, were met with little enthusiasm. Speculators had positioned themselves in expectation of some form of monetary "Shock and Awe". The prosaic reality fell well short of their expectations, thus undermining attempts to further weaken the Euro in order to nudge inflation higher. The ECB now faces its own reality, that without a much more vigorous expansion of QE it will face the same loss of credibility as the BOJ.
Clearly enjoying the ECB's discomfort, at the markets underwhelming reaction to the latest ECB move, Jens Weidmann did some verbal intervening of his own to add to the chaos created by the strengthening Euro. According to his baseline scenario, the strengthening Eurozone economic data support his thesis that commodity disinflation is a tailwind that is already having a beneficial impact. In his opinion the strengthening Euro, he hopes to maintain, will therefore provide the tightening effect that the German economy needs.
So embarrassing and counter-productive was the markets underwhelming price discovery, compounded by Weidmann's pot-stirring, that ECB Vice President Vitor Constancio felt the need for some verbal intervention of his own. According to Constancio, "the markets got it wrong in forming their expectations. They did indeed have higher expectations than were there and that's why they reacted like they reacted but that was not our intention". The problem with his view is that the Mario Draghi and several other Doves said and did nothing to correct the markets overzealous discounting of said "higher expectations".
ECB Governing Council Member Jan Smets, undermined Constancio's explanation and nudged market perceptions towards Weidmann's baseline. According to Smets, the improving data shows that the current QE expansion is already working. All the ECB has done therefore is to add an insurance guarantee, that this process will not be ended prematurely or through lack of effort. Smet's analysis sounds less like QE expansion therefore, and more like QE maintenance.
The bottom line is that Draghi's credibility has been lost so that he must now overwhelm with actions and not words. Unfortunately, his underwhelming words have already boxed him in and limited how aggressive he can now be, in the absence of economic data which demand stronger action. The direction of the Euro is now no longer in the hands of Mario Draghi, so that his ability to create inflation has gone. He must therefore wait for deflation to set in, in order to give him the cue to act more boldly. Consensus, a dangerous thing to hold in the Eurozone, does not expect any rise in interest rates in the Eurozone until Draghi reaches retirement. Increasingly, the fate of the Eurozone is beginning to resemble that currently being observed in Japan.
In the last report the thesis of the "transition" phase in China's tactical manoeuvring to weaken the Yuan post IMF SDR basket entry, was corroborated by the PBoC Deputy Governor Yi Gang. Further evidence of this "transition" was provided by rumours that Premier Li Keqiang will soon be introducing a new eponymous "Li Keqiang Index" economic dashboard indicator. Allegedly this new index will more accurately reflect the "transition" from a manufacturing to a service sector driven economy. Rather too conveniently for some, the new index is dropping signals from the sectors and subsectors that are currently causing the Chinese economy the greatest headwinds. In addition, this new index will also have an amorphous vector related to the very subjective definition of "wellbeing".
It seems that Premier Li is therefore seeking to divert attention away from China's real economic problems and fudge the new economic indicator with a subjective judgement. The "transition" phase therefore represents an underlying attempt to positively frame perceptions, whilst the problem sectors of the economy are administered with a traditional stimulus of currency depreciations. China is therefore continuing to be mercantilist at heart, despite claiming to be in "transition".
This "transition" phase is becoming far from smooth. A confluence of events has conspired to draw attention to the actual SDR basket constituent membership level of the Yuan. Having strong-armed the Yuan back from an excessive fall, in order to create an appearance of stability to facilitate SDR basket entry, the authorities then saw the trap door opening under the currency again.
The authorities signalled that the level of state intervention in the equity market would be scaled back. There was then a significant knee-jerk negative reaction in equity prices in general. More specifically, the shares of brokerage houses took a big hit. This hit was amplified by rumours surrounding investigations into their activities. Evidently some of these houses have been overzealous in projecting the level of government intervention in the markets. This zeal has led to a bubble in valuations, of the indexes in general and especially brokerage house shares. Just to push equity averages through significant support levels, stories began to circulate of increasing company failures to meet debt payments. Continuing reports, of weakening industrial earnings, then added to the fears in relation to these debt payments.
The general conclusion is that if the government buyer of last resort will not support the equity market at these price levels, then the poor earnings and rising corporate failures justify a significant correction to discount the true economic fundamentals. Such a discounting of these economic fundamentals, had led some to the conclusion that the Yuan's weighting in the IMF SDR currency basket should therefore be lower than was initially predicted.
President Xi Jinping is not betting on the economic boost of a potential fall in the Yuan. He signalled that he is reaching for a traditional fiscal stimulus tool, when he stated that the remaining 70 million Chinese classified as living in poverty will be lifted out of their lowly status by 2020. This equates to roughly 1 million people per month between now and then. Although this would be a huge fiscal stimulus in any other nation, relatively speaking in Chinese terms it is small. There is therefore little chance that this fiscal policy strategy will significantly move the Chinese growth needle. In fact it may just lead to further overcapacity in fixed assets with no use.
Currently the 70 million poor are largely agrarian societies. Industrializing them, in a global economy which does not require the current level of Chinese industrial output seems misguided. New roads and infrastructure will doubtless improve their quality of life, but will not solve the problem of how they can gainfully employ themselves.
(Source: Bloomberg - link)
The symbolism of the formal entry of the Yuan into the IMF SDR currency basket was interesting to see. The IMF tried to disguise the fait accompli nature of the formality in this event, by sternly opining that China would still have to press on with its economic reforms. Premier Li Keqiang then responded with alacrity, using the required words that he will be ruthless in his culling of the "Zombie" Chinese industries. As we have already seen however, with the unveiling of the new "Li Keqiang Index", he has no such intention of doing so. All he intends to do is divert attention away from the plight of the "Zombies". The "Zombies" are still where the majority of the working population obtain the welfare distributed by the central government from, via the State Owned Enterprises (SOEs). With no clear plan to restructure the SOEs, one cannot take Premier Li's words at face value.
The signals from Finance Minister Lou Jiwei give a much clearer indication of China's intentions and capabilities. According to Finance Minister Lou, a programme to refinance local government debt at lower rates of interest will be expanded. The "Zombies" are very much alive and kicking.
Broadly speaking, the reweighting follows the current global macro thesis that supports the stronger US Dollar. The Dollar retains its weighting, thus reinforcing American hegemony in the global economic system that has existed since World War II. This point was underlined by Treasury Secretary Lew, in the official American response to the Yuan joining the SDR basket. He said that the US Dollar "remains the reserve currency of the world for a good reason" thereby implying that the Yuan still does meet all the requirements of a true global reserve currency. Secretary Lew also put the Chinese on notice that America was going to hold them to their commitment not to competitively devalue. China's "transition" phase is therefore going to be a protracted affair, before a much needed devaluation of Yuan will be globally accepted.
In the final analysis, it was the Euro which gave up the most ground in order to accommodate the Yuan's ascendancy. This reweighting therefore reinforces the strengthening US Dollar theme, of the divergence story between American and European interest rates. It also "potentially" weakens the Euro against all of its SDR basket trading partners. The chain reaction in the foreign exchange markets has therefore been set up.
ASEAN central bankers have been keeping a watchful eye on the destabilizing threat, from a Yuan devaluation combined with a hike in US interest rates. The combination is lethal. China will steal a march on its export competitors through devaluation. America will suck capital away from Asia with higher interest rates and raise borrowing costs for Asian businesses. With these twin threats looming, the confederation of Asian central bankers named SEACEN met in Manila to collectively form a strategy. Thus far, all they can agree to do is cooperate and coordinate more closely. They hinted that new policy tools will be required, but none were being discussed at the meeting. The value of the meeting therefore only served to signal that the risks associated with the Yuan devaluation and Fed interest rate hike are giving ASEAN central bankers sleepless nights.
BOJ Governor Kuroda clearly shares the sum of all SEACEN's fears. Having recently disappointed, by holding firm on further QQE expansion, he started to move in anticipation of the headwinds debated by SEACEN. He took up the BOJ's pole position on the QQE starting grid, when he told business leaders in Nagoya that "The BOJ will respond without hesitation if it sees the need to do so to achieve its 2 percent inflation target at the earliest date possible". In the last report Kuroda's predicament, in relation to falling wage demands and decreasing wage expectations, was summed up thus:
"He now faces the dilemma of whether to consider an even larger expansion in QQE, in order to meaningfully attempt to shake inflation expectations, or to accept that he has been beaten."
Lone dissenting BOJ policy board maker Takahide Kiuchi urged Kuroda to give up on his futile quest to hit his inflation target. Kiuchi's suggestion is based on his opinion that commodity price deflation, the diminishing annual base valuation effect of the Yen and endemic economic weakness are insurmountable hurdles. In his opinion, QQE should be cut in half because it now presents economic dangers greater than the potential benefits in view of the hurdles presented.
Based on his latest pronouncements, it would seem that Kuroda has blinked first and gone for an expansion in QQE. He emphasized the new urgency in his thinking when he followed up some remarks in Nagoya by saying that "somebody has to show an unwavering resolve and change the situation. This means that, when it comes to price developments being at stake, the bank must be the first mover". Evidently Kuroda is now showing his resolve.
If the Yuan then devalues, he will be in a position to swiftly react. Clearly, Kuroda is thinking that the Fed's interest rate increases are already deeply factored into Dollar- Yen. The risk now is that the Yen strengthens in a "risk-off" reaction to both the Fed and a Yuan devaluation. Kuroda is positioning in order to deal with this Yen strengthening risk. He is also positioning himself for a weakening of the Euro against the Yen, as the Euro loses relatively more of its IMF SDR basket weighting. It was Yen strength versus the Euro, that triggered the massive unilateral devaluation of the Yen that has recently run into a brick wall. Clearly Kuroda is worried about Euro weakness in addition to Yuan weakness.
In the last report, the "comedy of errors" at the Bank of England in relation to its equivocal communications and Governor Carney's procrastination was discussed. Combined with George Osborne's politically expedient U-Turn manoeuvre on public spending, the situation was seen to be conspiring to undermine Sterling. Into the Bank's hand was inserted the new card, presented by the view of its incoming rate-setter Gertjan Vlieghe. Vlieghe's first signal evinced no concern over the need for an immediate rise in interest rates. Sterling therefore weakened further to reflect his position, and the risk premium in Sterling assets rose further.
The last report characterised the very British economic predicament of a pro-cyclical fiscal deficit, which came about as a result of failure to manage the counter-cyclical fiscal stimulus post "Credit Crunch". In recognition of this fact the Bank of England has recently blundered on with measures, which will precipitate the next economic slowdown. Commercial banks will allegedly be forced to set aside capital as buffers by as early as March 2016. The Bank of England says that this is prudent credit management strategy, in order to create balance sheet strength to deploy resources to stimulate the economy when it shows signs of slowing. The Bank of England then disingenuously presented the results of its stress tests, which showed some concerns over the state of the buy to let mortgage sector. This begs the question of the Bank of England's true motivation in raising capital adequacy standards. Perhaps the Bank of England does not trust the models used in the stress tests.
In practice, the banks will cut back their lending books in order to meet the new capital adequacy standards. By so doing they will therefore create the economic headwind that the Bank of England is asking them to prepare for. The fiscal deficit will also increase as the economy slows and tax revenues fall. By trying to signal prudent macro-stability policy, the Bank of England has therefore undermined the system and made it unstable. Sterling will therefore have to take some more strain. The Bank of England has thus served notice that there is trouble on the horizon and provided the source of this trouble in the process.
This notice was served in the characteristic faux intellectual style of Governor Carney. When asked directly for guidance on interest rates, he went off on another famous tangent. In the latest tangential response, commentators were directed to observe the intricate workings of the Financial Policy Committee (FPC) rather than the Monetary Policy Committee (MPC). In other words, rather than give MPC guidance, Carney is providing FPC obfuscation. According to him the FPC will be doing the tightening, as aforementioned above in the step that leads to the banks shrinking their lending books.
The FPC will trigger the slowdown that the MPC is then forced to deal with. The FPC then signalled where the next shoe will fall when the new financial crisis unfolds. The next flashpoint will involve the systemically important asset managers.
FPC is now in the process of investigating this risk, especially in relation to leveraged positions and the mismatch between managers' long-term investment portfolios and their short term fund redemption features. Any move by managers to close short term liquidity provision windows going forward, should be viewed through the narrow prism of the FPC's view on the inherent systemic risk within the sector.
The last report explained how David Cameron and Chancellor Osborne needed to carefully manage public expectations, so that enthusiasm to bomb Syria did not become enthusiasm to leave the EU. Osborne's problems in this regard were highlighted when he was forced to hotly deny that net inward migration is needed to hit the magic growth numbers behind his recent Autumn Statement U-Turn on public spending. Cameron meanwhile, was has having by far the easier part of the partnership in leading Parliament to follow public opinion in relation to bombing "Daesh" (fka ISIS). On the other hand, Cameron is facing the risk of his deal to reform the EU blowing up prematurely as he persists in trying to get the deal done by Christmas. Osborne meanwhile, sees no problem with holding an EU referendum in 2017. Between them, they are probing and nudging public opinion to the limits.
Going into the US November Employment Situation report, expectations of a December lift-off in the tightening cycle were already well discounted. Atlanta Fed President Dennis Lockhart then helped the discounting process into its maturity when he said that "I believe the national economy is on a reasonably solid trajectory", before the employment data was released. He now sees a "compelling case" to move at the next FOMC meeting. Vice Chairman Stanley Fischer then apparently signalled, that he believes that the global economy is strong enough to weather the storm of the Fed normalizing. Or did he?
Fischer then showed a little more of his hand, when he qualified his comments on the global economy with his own ideas about the known unknowns in what is broadly termed the "shadow banking" industry. It is here that Fischer worries about the impacts of the Fed tightening, because the banking system that the central banks are mandated to regulate are far more transparent. Interestingly "shadow banking" includes the asset management industry, a matter of concern for the Bank of England as we have seen previously in this report.
It is evident that central bankers are worried about the impacts of the next financial crisis in the "shadow banking" sector. This fear also suggests that central bankers are acknowledging that QE in general went into financial assets and not the real economy. Any crisis, resulting from a withdrawal of QE, will therefore be magnified throughout the asset management and shadow banking sub-sectors. The central banks have therefore just confirmed that they have created bubbles in financial assets and lack the understanding of how these will deflate. In the absence of said knowledge they are therefore going to incrementally withdraw from QE beginning with the Fed and then learn the results on the job.
Fischer then signalled how financial stability policy tools will be implemented, when he suggested that minimum capital requirements will be put in place for securities lending. In effect the Fed is going to try and seize control of the asset markets, through the collateral markets that finance them. Perhaps more significantly, these new financing margin rules and limits are still on the drawing board. In Fischer's own words, "what you do not know really can hurt you". It is highly probable therefore, that the FOMC will stumble blindly into a situation that will hurt the economy.
In order to mitigate the risk of stumbling blindly into the next crisis, St Louis Fed President James Bullard advocates avoiding a repeat of the mechanistic sequential tightening process applied with disastrous consequences between 2004 and 2006. This view is also held by Fed Governor Lael Brainard. Additionally, she is concerned by the headwind blowing from the stronger US Dollar. Chicago Fed President Charles Evans further tempers enthusiasm, for aggressive tightening, with his opinion that he is scared about lifting-off in December.
Whilst this collective opinion sounds great in theory, in practice it is fraught with risk. Since interest rates are already at the "Zero Bound", as the US domestic economy is simultaneously declining against a weakening global backdrop, there is very little room to finesse this manoeuvre. Taking into account that inflation is already low, the room to increase real interest rates is limited even further. A persuasive case could easily be made, that the Fed has already missed the opportunity to normalize interest rates significantly enough to provide the cushion needed for an economic stimulus when things slow down. The case for a US fiscal stimulus therefore grows stronger every day, as the Fed gets farther behind the curve.
Any serious attempt at exiting QE, with either higher interest rates or tighter collateral margin financing rules, can therefore be discounted at this point in time. The Fed (and also the Bank of England) are literally making the rules up as it (they) goes (go) along. Market liquidity is therefore an illusion and therefore volatility will be extreme until the new rules of the game have been made and disseminated to the players. The good news, however, is that the Fed has no intention of destroying the asset bubble, that it has created, by removing all of the QE that it has applied. The Fed is now content to sit back and permanently leave QE in the financial system, whilst it tries to figure out how to manage the bubbles in financial assets that it has created.
Absurdly, inflation is the last thing that the Fed wants to see, despite its words to the contrary. Inflation would oblige the Fed to do more about tightening monetary policy at the expense of financial stability policy. QE until now locked up in the reservoirs of asset bubbles, would then exit them into the real economy, This would then create the kind of hyperinflation that the Fed couldn't deal with, without killing the real economy the way Paul Volker once did.
The conclusion to be drawn on both the Fed and the Bank of England, therefore, is that both institutions are more likely to tighten monetary policy using financial stability tools. This implies that QE will therefore stay in the system and be managed by financial stability rules. QE is therefore permanent, so a permanent expansion in the money supply since the "Credit Crunch" is now being undertaken. Where this manifests itself in asset price bubbles, the central banks will attempt to manage these values with mainly financial stability policies.
At the other end of the spectrum, ECB Governing Council member Ewald Nowotny signalled that there is a faction within the ECB that is aware that QE primarily creates asset price bubbles that need to be managed. Rather auspiciously, Nowotny alluded to the housing market; the source of the bubble that almost ended the global financial system in 2008. For Nowotny however the threat of a property bubble, however real, is far less significant than the threat of deflation. His faction within the ECB is therefore actively creating a bubble in the Eurozone property market.
The gold price is seemingly totally unaware of these latest developments in central banking thought leadership. Central banks are also happy to see the falling gold price give them cover behind which to hide as they permanently debase their respective currencies.
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