Emerging Markets News: QE Dissolves Rapidly Cooling Britannia Into Committees

Includes: EWU, FXB, FXE, IEV
by: Adam Whitehead


Sterling's safe haven status is being questioned by economic and political developments.

There is a risk that Britain leaves the EU.

There is a smaller but growing risk that Britain itself splits up.

Britain may potentially become the developed world's least democratic nation.

Britain may be exposed as an emerging market nation masquerading as a developed nation.

(Source: The Guardian - link)

A recent Deloitte's survey found that British CFO's are now at their most pessimistic about the UK economy since 2012. Brexit fears list high on their worry list. Suddenly the safe haven status and predictability of UK policy action has dissolved. UK industrial production fell precipitously in December, by the most in almost three years. The British Chambers of Commerce (BCC) joined the pessimists club, in its latest survey which reported that the economy is losing momentum. Manufacturing is at its lowest in six years; and manufacturers cite Sterling strength as a significant headwind. The capital markets have scaled back expectations for interest rate increases this year. What is certain is that the economy is getting worse.

The political and economic challenges to Sterling's safe haven status were evaluated in the last report. Observers have noted the not so subtle dropping of the words "long term economic plan" from the Prime Minister's vocabulary book. Perhaps this is because the significant parliamentary working majority, enjoyed by the Government, has given the Prime Minister a false sense of security. He may now feel that he does not need to be reassuring when he speaks; so that he can crack on with what he intends to do. Perhaps there is no plan at all. Theoretically speaking, all may be revealed soon at Davos; where the Prime Minister, Chancellor and Bank of England Governor shall be attending.

Perhaps in fact there is a plan after all; that has lain dormant until a second term and working majority were secured at the polls. The first glimpses of this potential plan suggest that it is not in fact conditional upon a parliamentary working majority; or the blunt application of the traditional three line whip when it comes to voting in the House. Sterling's safe haven status is predicated on the perceived stability of the Government's parliamentary working majority. There are however signs that the Government intends to avoid even going through the Parliamentary consulting and voting process at all; thereby signaling that a Parliamentary majority is now meaningless and British democracy has been hijacked. How will Sterling react to this?

It recently came to light that the Government intends to use a committee process, to turn the assistance grants system for the poorest children in the country seeking university entry into loans. Allegedly, this is being done to save money and cut the fiscal deficit. The selection of the poorest demographic in the country, to enact said fiscal austerity however, hints that something far more ideological is in process.

The use of a committee structure, rather than the party democratic process, suggests that the British Government intends to "rule" by committee going forward rather than "serve" the country through elected officials. The fiscal deficit will therefore be addressed by committee, rather than through the traditional forum of the Chancellor's House of Commons communicated, debated and voted budget. By logical inference, future economic policy in the United Kingdom will be made by committee rather than by government. Why stop there, why not run the whole country this way? The quantum shift and its implications are massive.

The unfolding plan, initially evinced by Chancellor Osborne, is to attack the fiscal deficit savagely. Such a savaging itself will weaken the economy, because the private sector has been notably absent from the recovery since the Credit Crunch. Such a savaging is also conditional upon there being intrinsic economic strength, to mitigate the headwinds from a reduction in fiscal spending.

Unfortunately, George Osborne was forced to obliquely admit that there is no such intrinsic strength; when he blamed a "dangerous cocktail" of global forces for the UK economy's current problems. Having U-Turned already in the autumn, Osborne is facing another embarrassing second attempt at passing his deficit cutting plan. Pushing it through by committee, rather than through the Commons in full view of the voters, is much more politically expedient.

The first challenge to Sterling comes from the Brexit. Unfortunately for the Government, this is something that cannot go through a committee; but must pass through a referendum process. The latest ORB poll showed that, of those polled who have made a decision, the majority are in favor of leaving the EU. Prime Minister Cameron appeared to bow to public opinion, when he allowed his own party's MP's to campaign with their hearts for or against the Brexit. In doing so, he has deflected criticism from his own style of government; and also created a weapon to extract larger concessions from the EU negotiators when he faces them next. Chancellor Osborne could be seen to be almost gloating when he gave an interview; in which he reported that he was "pretty optimistic" that Britain would get the prized concessions that Prime Minister Cameron was negotiating for.

Cameron's position was reinforced during a Treasury Select Committee hearing on the Brexit; at which Barclay's most senior investment banker Mark Astaire opined that London would still be the premier financial center if the Brexit occurred. In the City there is far less fear of London losing its position, as a major financial center, in the event of the Brexit. Citigroup's Chief Economist Willem Buiter handicaps the odds of the Brexit at 1 in 3 currently.

Having secured his domestic position, Cameron then went out to bat in Brussels. There he was able to frighten his European counterparts; into believing that a deal with him is better than taking the risk of a referendum no vote when the British vote on EU membership. His confidence thus allowed him to report that he is certain of a deal with the EU over welfare payments to immigrants by February, so that he can then hold a referendum on EU membership. Having secured concessions from the EU, his own position is safe and the potential for the Brexit has been somewhat reduced.

The last report suggested that the growing probability of a breakup of the United Kingdom was being contributed to by the Government's fiscal cutbacks. The irony of the situation is epitomized by the Government's alleged commitment to the "One Nation" theme made famous by Disraeli. "One Nation" is evidently code for "Many Committees". The proposed devolution of powers to make the country's government more representative is a case in point.

The devolution of power to the regions, is now being widely exposed as the cover story for the real story of enforced regional fiscal spending cuts by committee. Since the North of England is disproportionately overweight fiscal welfare spending, any cutbacks in spending will contribute to its split from the more affluent South. Since the North of England is also disproportionately overweight asylum seekers, the equivocal attitude of the Government towards it when it comes to disproportionately sharing this national burden is also coming under greater scrutiny by the local inhabitants of this region. Both evolving dynamics increase the fissile political and economic momentum.

This real threat of dissolution was recently highlighted by the rising floodwaters in the North of England. The local government services response to this national disaster was inadequate. It was hamstrung by the disproportionately higher cuts in local government spending and lower spending on flood defenses in this region, compared to those in the South. The "North-South funding gap" is now a political issue that is code for the dissolution of the Union.

George Osborne has been directly identified with the "North-South funding gap". The findings of a New Year YouGov poll now put him way back in third place in the running to lead the Conservative Party. The political strategy to apply major austerity measures in the form of cuts, under cover of promoting regional autonomy has now been exposed. Britons evidently still wish to remain cohesive and united, at this point in time. If Osborne is therefore to succeed with his strategy, the Tory Spin Doctors need to add some criminal veneer to the framing of the intended recipients of welfare cuts. Alternatively, the current docile holders of Sterling and Gilts need to revolt in large numbers; and enforce the austerity that he desires. Such a revolt would however be even more fatal for the Conservatives and especially Osborne.

It therefore looks as though Osborne's ally Mark Carney is going to have to step in and provide the low yields and relative calm, in order to keep Britain's overly indebted superstructure afloat. Carney has shown himself to be an astute political animal. He and his team have therefore already started to take back much of the expectation of higher interest rates that was discounted by the markets. If Osborne can't sustain low Gilt yields through fiscal austerity, the Bank of England will have to do the needful with its QE purchase program instead.

Carney can therefore be expected to follow Janet Yellen's lead of gradually normalizing interest rates, but even more gradually than the Fed. By normalizing gradually, the docile holders of long dated Gilts can be placated enough for their continued sponsorship of Britain's low cost of financing. None of this may be enough to save Osborne's Prime Ministerial ambitions though. He may therefore have to take one for the Conservative team and put his party before himself. If the party is less popular with him at the helm, he will therefore have to switch positions and become Foreign Secretary instead of party leader when Cameron steps down.

(Source: Telegraph - link)

Carney has dutifully obliged his creator, by telling some little white lies about Britain's unsustainable debts. According to Carney, there is neither a legacy of the counter-cyclical stimulus post Credit Crunch, nor the pro-cyclical fiscal stimulus that has followed it during the QE phase. In his words, Britain is not in the grip of a "debt fueled" recovery. He is however willing to concede that household debt poses an "indirect" threat to the recovery. This "indirect" threat is however allegedly mitigated by the fact that the banks have recapitalized and have got adequate counter-cyclical capital buffers in place. Carney's bluff is about to get tested and very possibly called. Carney and his team are as yet in no position to have their bluff called though.

The Bank of England has already been struggling to regain its credibility, after the debacle it has had with its guidance policy. After sending confident signals, that it will be following the Fed with higher interest rates, the Bank has suddenly got cold feet and started to take back its tightening as the data suggests that the economy may be rolling over. Governor Carney has been the principle sufferer of this loss of credibility. The jury is out, over his performance to date, as he seeks to roll over his lucrative contract. The Adam Smith Institute became the latest opinion former to deliver its verdict on Carney and his team. The verdict however hinted at a potential conspiracy involving itself, Carney and Osborne.

According to this Right-Wing think-tank, the Monetary Policy Committee (MPC) should be abandoned altogether. It appears that Carney and the MPC merit an F grade with the Adam Smith Institute. They should allegedly be replaced by a kind of currency board; in echoes of Milton Friedman's view on what a central bank should do. Whilst this suggested course of monetary policy action may sound hypothetical, it is entirely consistent with Government's new initiative to conduct economic policy by committee rather than through Parliament.

Nothing short of a "coup by committee" is taking place in Britain. The country may be on the verge of becoming the least democratic nation in the developed world.

What is interesting to note is that this new monetary policy currency board is supposed to use QE as its only policy tool; and should target nominal rather than real GDP as its key performance indicator. QE should then be expanded or contracted to counteract the movement in nominal GDP. It will be interesting to see how Carney reacts to this recommendation going forward. If the MPC is headed for the bin, he will need to re-invent himself … or perhaps not.

Fortunately for Carney, earlier in his career at the Bank, he was a major proponent of nominal GDP targeting. There is therefore an inherent sense of collusion between Carney and this think tank report. How Carney handles his MPC colleagues, if he is in on the scheme to make them redundant, is going to make for an interesting dynamic. Carney has become infamous for gimmickry without substance, so all this nominal GDP stuff should be just up his street. Once again, Britain and its central bank are trying to differentiate the economy and its monetary policy from the global crowd. The jury is still out on both counts.

The jury is however in on the QE process; and QE has been ruled out by it. Now that the Fed is in normalization mode, the Bank for International Settlements (BIS) has decided to debunk the myth of QE. According to the BIS, the US economy rebounded, the first and the greatest after the Credit Crunch, because it had embraced its debt liquidation phase the earliest. The rebound had nothing to do with QE per se.

The Adam Smith Institute's embrace of QE seems a little conflicted at best therefore. Indeed Britain's rebound from the Credit Crunch can be strongly attributed to the government's counter cyclical expansion of the budget deficit, rather than QE, despite George Osborne's alleged fiscal austerity campaign. Britain's fiscal austerity never happened. The Government borrowed and the Bank of England financed the borrowing. In fact the fiscal stimulus was prolonged for so long, that Britain now has a pro-cyclical deficit to compound its counter cyclical fiscal deficit.



The reason for the Adam Smith Institute's embrace of QE seems to be much murkier. A clue to the depths of this murky strategic pit, is to be found in a book recently published in Japan. Reiko Tokukatsu, a strategist at BNP, has published a critique of the QE and QQE processes. QE, QQE and negative interest rates were exposed as simple forms of wealth confiscation from lenders by governments.

Given Britain's yawning fiscal deficit, it is therefore highly probable that the Government may have to avail itself of further wealth confiscation; especially if its attempt to rule by committee is thwarted. Governor Carney and his gimmicks have therefore been nothing more than vehicles for wealth confiscation. Going forward, there will apparently be more of the same.

First however, the Chancellor will shake down the members of society, who can least afford to protect or finance themselves, to fund his austerity drive. Having plucked this lowest and least juicy fruit on the tree, he will go after the juicier consecutively higher ones. This harvesting venture will take him into the broad swath of the middle class, where resistance to austerity lurks; and also where valuable votes can be lost. Encountering any significant resistance here, Governor Carney's QE engine of last resort will be resorted to swiftly in order to confiscate from them by stealth.

(Source: The Daily Shot - link)

Even murkier still is the related performance attribution of Listed UK Economy Inc. in 2015. There was a distinct lack of earnings and a distinct wave of equity speculation, in the form of P/E multiple expansions over the year. Presumably Mark Carney gets the City's vote, to stay on as Governor or even QE Manager in the Adam Smith Institute's brave new world of Britain. Evidently the only thing that can save the City and London is QE and more asset price bubbles. Britain is rapidly becoming the emerging market story that never corrected along with its peer group when the US Dollar rallied. Something, either Sterling or Sterling asset prices have to give, in order to reflect this emerging Banana Republic outcome probability. If the Adam Smith Institute and Mark Carney have their way, it will most likely be the currency.

(Source: The Guardian - link)

After the Bank of England left interest rates unchanged sentiment about Sterling's safe haven status began to dissolve further. Expectations for the first interest rate increase have now been pushed back to November this year. There is now a growing consensus that the Pound will weaken to levels last seen when Margaret Thatcher was Prime Minister. No doubt this sentiment is being inspired by memories of the Pound's ejection from the ERM.

Behavioral economists will understand that speculators, who think in terms of models and stories, will equate the Brexit with the ERM exit and therefore weaken the pound. This simplistic association will drive the price action; but as the trade becomes crowded the speculators will be frustrated by periods of price action going violently against them. The pound has weakened significantly already, suggesting that this one-way bet against it is going to be tested in the immediate future, with painful consequences for those who are late into the trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.