ECB Hikes, Powell the Matador Up Next

The ECB hiked 75 basis points today. There were spikes in equities, the euro and bonds, and then it faded. The question for today is whether this pullback hints at continuation of the prior three week trend or if this is a buying dip in a developing countertrend rally. I'm long TLT coming into the day, with a tight stop. Possible double bottom in play.

The spread between US and China govt bonds broke lower this week, but not Japan. The 2s10s has been rallying, but that is not a long-term positive sign because it's coming via the long-end rising faster than the short-end. Prior recessions (after 1982) saw a soaring spread because short-term rates fell in recessions. For now, the spread isn't as interesting as what bonds themselves are doing.

ZeroHedge was talking about a snap reversal in yen yesterday. It's not very actionable, but that's ok. Sometimes it's good to be reminded of potential trades even when the setup is not quite baked through. Looking at CNYJPY, one of two things is coming: a pullback in the dollar and reversal in charts like CNYJPY or something like July 1997 and Setpember 2008.

Bear markets are strange because it pays to have a very long-term macro focus, but the news feed is wild because years can be compressed into days. Rallies that take months to unfold in bull markets can happen in hours. Right now I'm lightly positioned waiting for reentry on shorts, and maybe go long if the rally has legs. Zooming out though, the Federal Reserve is still trapped. Prematurely declaring victory over inflation is a very expensive mistake. They must err on the side of overtightening. A recesssion is already underway and it will probably get worse. The Fed is going to take flak for that. They have an excuse though: we were fighting inflation. Everyone told us to fight the inflation. Failure is both inflation and a recession. That's why I expect stocks will tank around the time ZB starts moving higher, but the current moment might fool a lot of bulls who misinterpret what the bond market is saying.

ECB Emergency Meeting, FOMC and Japan's Crisis

ECB calls surprise meeting as borrowing costs rise

European Central Bank policymakers called an emergency meeting on Wednesday, as more indebted eurozone states have come under pressure from rising borrowing costs. A week after a regular gathering, the governing council will hold an "ad-hoc meeting"...

...The switch in the central bank's policy has raised the spectre of "fragmentation" in the eurozone, where the borrowing costs for some, more indebted members rise faster than for others.

My guess: Powell told the ECB a 75 basis point hike is coming. Spreads have been widening in Europe and the market action makes an emergency meeting warranted, but why not Monday or this Friday? The day of the FOMC announcement makes me think they want to project stability ahead of a surprise. Even if I am wrong, I view the emergency meeting as a sign a culmination move is underway or possibly even over. 

There hasn't been a highlight-reel blow-up like Bear Stearns yet, but the market fell about 20 percent into January 2008 and then retested that level in March 2008. It then rallied on the Bear Stearns bailout.

My view of the current situation: the economy is in worse shape than in 2000 and 2008. The Fed really screwed up leading into 2000 and set the course for everything that followed. The 2008 crisis was one where everything happened very rapidly. There was a slow buildup with housing topping around 2006-2006, the Bear Stearns hedge funds failing in August 2007 and an emergency rate cut by the Fed, auction securities failed in February 2008, Bear Stearns in March...and then everything collapsed at once. 

I do not expect everything will collapse at once this time, at least not until there is actual deflation in the economy. Instead, I expect something a longer period of decline similar to the 1970s. "Authorities," such as the ECB today, will step in and try arresting the decline. There is a case to be made for slowing the process of rate hikes, drawing out the pain to lessen the risk of a catastrophic collapse. 

There is one exception for a crisis. A sovereign debt blow-up and currency crisis in a major nation. Candidate number one is Japan: Japanese Bond Futures Suffer Biggest Rout Since 2013, Trigger Circuit-Breakers After 'Soros'-Style Bets Build

I will kick myself if this crisis kicks off now because I closed out my JPY shorts, but I do not think this is coming right now. Like the housing crisis though, a JGB-yen crisis can be seen from miles away, in fact it was seen at least a decade away. This phase from John Mauldin was seared into my mind 12 years ago: Japan Is a Bug Searching for a Windshield

Maybe we'll do it like Japan? Japan is a disease. They're like a bug searching for a windshield. It's a dying country. Nominal GDP is where it was 17 years ago. Plus, the population is very old. When they stop funding their own debt [as a result of retirees ceasing to save], it's going to get ugly. You're going to see the yen valued against the dollar go to 100, and then 120, and then 250, 300. They won't care how low it goes. They can sell more Hondas and Toyotas to us. They're just going to print money. 40% of their budget right now is borrowed. Think about that. They're in deep dire trouble with a government that has no clue. I think Japan will implode within the next two to three years. It will not be good for the world.

This event didn't happen in two or three years, but most people thought QE1, QE2 and QE3 would lead to the inflation seen now, in 2022. It took catastrophically bad policy in response to a novel respiratory virus, along with years of stupid energy policy, to get us to this point. Long Nikkei/short yen will be one of the trades of the decade if events continue playing out on the current trajectory. 

Short-term: I expect a bounce in stocks, a pullback in the dollar. After that, the deluge.

Zaijian Inflation, For Now

Higher energy is already crushing economic growth forecasts. The stock market looks to be rolling over and the Federal Reserve is ready to taper. Alhambra: Chip Shortages, Crude Boiling, Fed Explosion And…No Inflation

Inflation alarms were positively deafening in September:

The supply situation is even more critical for standard logic ICs and power-management discretes such as low-voltage MOSFETs and tantalum capacitors, which are now experiencing shortages and are effectively on allocation status, meaning suppliers are unable to respond to unforecasted demand. For standard logic ICs, allocation is continuing for the fourth month and is likely to persist until the end of the third quarter.

The situation so stretched, it spills over into other forms of indispensable tech like for LCD makers who “didn’t recognize the limited capacities of key material suppliers before fixing their LED TV panel shipment targets.” In other words, they got way ahead of themselves seeing huge profits from what they were told would be always rising demand apparently without stopping first to consider whether or not the commodity space would be able to provide the necessary materials inputs.

In particular, PMMA and PET materials are in significant shortage. PMMA and PET suppliers are slowly expanding capacity since they need time to add new plants and face financial limitations.

Put these alongside rapidly rebounding crude oil and the public understandably braces itself while conditioning its anger for only Great Inflation 2.0. What chance massive money printing and a serious supply shock goes any other way?

This year has been all sorts of trouble for chip shortages and tech problems, for sure, but those quotes above are not contained within some article written in September 2021, rather September 2010.

What took place back more than a decade ago really does sound weirdly familiar even though we’re being led to believe what’s going on this year has never happened before in human history. Suppliers then, too, were gutted by a huge global recession, so that when demand began to rebound from the lows it did so much faster than supply could. This quite naturally pushed up prices for producers and consumers alike, small “e” organic economics.

And the same point here: Tapering Or Calibrating, The Lady’s Not Inflating

QE in any form doesn’t actually work and never has (for more than twenty years). It has uniformly been unable to accomplish a single one of its goals through any of the three theorized channels: expectations, falling interest rates, and portfolio effects.

As to the latter of the trio, there’s absolutely no lending. Apart from panicked corporations desperate for liquidity during last year’s GFC2, loan activity to companies in Europe since has been more recessionary than inflationary.

Even overall lending (mostly to consumers) has been lackluster and clearly unaffected by QE’s, tapering QE’s, more QE’s, and now a promise to reduce QE without calling it a taper. Despite all of it, nada.

How long will a deflationary wave last? At least long enough for a 20 percent stock market correction.

ECB: Recovery Threatens the Recovery, We Must Devalue the Euro

Bloomberg: ECB Ramps Up Bond-Buying Speed to Contain Rising Bond Yields

The European Central Bank pledged to ramp up buying government debt in coming months in a bid to a contain rising bond yields that threaten to derail the region’s economic recovery.

Policy makers expect purchases in the next quarter “to be conducted at a significantly higher pace than during the first months of this year,” according to a statement on Thursday. They kept the overall size of the 1.85 trillion-euro ($2.2 trillion) pandemic bond-buying program unchanged.

What kind of recovery is threatened by a recovery in bond yields? Answer: a fake one.

Market Insider: ECB To Accelerate Bond Purchases In Q2

In December, the PEPP envelope was boosted by EUR 500 billion and the horizon for net purchases under the scheme was extended to at least the end of March 2022.

The bank said it will not use the PEPP provision in full if favorable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over its net purchase horizon.

The PEPP purchases can be recalibrated if required to maintain favorable financing conditions to help counter the negative pandemic shock to the path of inflation, the ECB said. The bank will continue to reinvest the principal payments from maturing securities purchased under the PEPP until at least the end of 2023. The future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance, the bank said.

The size of the asset purchase program was also maintained. The monthly EUR 20 billion worth of asset purchases would continue as long as necessary, the bank said.

These will end shortly before the Governing Council starts raising the key ECB interest rates, the ECB said.

The Governing Council kept the main refi rate unchanged at a record low zero percent and the deposit rate was left at -0.50 percent. The lending rate was held steady at 0.25 percent.

Prices Are The Facts Now

"Prices have changed more than the facts, thereby creating a scenario in which the selloff will (eventually) need confirmation from the real economy that elevated optimism is warranted."

Not understanding the prices are the facts in the market now, that markets are divorced from fundametals and trading on their own formulations, is what will eventually wipe out central banks and all investors who don't understand it. If you want real facts, ignore market prices. Inside the market, prices are the facts.

Bass Rebuts Critics of HKD Short

The letter explaining the short on the Hong Kong Dollar, viewable at ZH: Kyle Bass Hits Back At Critics Of His Latest 'Big Short'

One section isn't a direct argument, but I think it bears consideration for those who think Hong Kong, China or any other nation have enough reserves:

This issue is analogous to the current debate surrounding the size of the United States Federal Reserve’s balance sheet. The extraordinary measures taken since the financial crisis led to the Fed’s balance sheet expanding to a peak size of $4.7 trillion USD. Beginning in the fall of 2017, the Fed began to reduce the total size of the balance sheet which now stands at $3.9 trillion USD and is forecast to shrink to approximately $3.5 trillion USD. Since 2018, a debate has ensued as to how much the Fed’s balance sheet could actually be run off. Between the USD currency‐in‐circulation and the Basel 3 Liquidity Coverage Ratios (LCRs) that US banks are required to satisfy, the Fed cannot possibly reduce its balance sheet anywhere close to zero. Our own estimate is that the Fed couldn’t go much below $3.5 trillion USD without causing severe interest rate volatility as banks would start to bid for fed funds in ways the Fed would have trouble smoothing out with open market operations. The ensuing economic consequences would be disastrous to a highly levered economy.

Therefore, if you can’t reduce your liabilities, you can’t reduce your assets by definition. The Fed originally said their balance sheet was going to shrink to around $2.5 trillion but they are giving up at $3.5 trillion. It turns out that banks needed more reserves than they realized, and they only learned this through bank surveys. But they also have started to have issues with controlling short term rates (which is why they keep cutting interest on excess reserves (IOER) because the fed funds rate isn't acting as they thought it should).

Most of the world hasn't deleveraged, instead leveraged up with debt to forestall a denouement in the credit markets. Among those who have, many have substituted public debt for private debt. The U.S. is in a relatively strong position vis a vis the rest of the world. The Federal Reserve is among those who deny the decline in reserves impacted financial markets, yet it is still abandoning its balance sheet reduction in contradiction to Chair Yellen stating this would only occur in concert with rate cuts. (Or is the Fed exploiting everyone's bad memory and telegraphing a September rate cut?) For a nation such as China to refuse balance sheet reduction (refuse to exchange renminbi for foreign currency), it is effectively floating the currency. For nation with a hard peg such as Hong Kong, refusing to reduce the balance sheet breaks the peg.

Most Important Currency Chart

This is the broad trade weighted U.S. dollar index. It includes, importantly, currencies such as the Chinese yuan. The index made a short-term high on December 14, 2018. The chart looks similar to the U.S. Dollar Index (DXY) over this time frame, with one difference: it made a higher high in 2018. DXY still has not exceeded its 2017 high and it was still 5 percent off the high at its 2018 peak.

Money has moved into emerging markets on the expectation that a repeat of 2016-2017 is underway. The post-election spike in USD was a temporary move in the midst of a broader rally in emerging markets and commodities. Tthese investors are betting USD has peaked, at least temporarily, and another rally in emerging markets and commodities is underway. They may even believe this is the big one and the U.S. dollar had made its ultimate peak for this bull cycle, in which case this index will break the lower trendline and keep falling all the way through 100.

A longer-term look at the chart shows why dollar "bulls" aren't throwing in the towel. The index was 126.16 on February 4 (it will be higher at the next update), a 2.5 percent move away from taking out the December high. It is also only 3.3 percent away from taking the all-time high of 130.21 set on February 27, 2002.

The two key components are the euro, which is by far the largest developed market currency, and the Chinese yuan, king of the emerging markets. For the U.S. dollar broad trade weighted index to break out or break down, both the euro and yuan will confirm it.

I remain "bullish" on the dollar. The bounce in the yuan and EM currencies was a relief rally with some possible political adjustment of the yuan ahead of major trade negotiations with the United States. The European and Chinese economies remain weak. Fiscal or monetary intervention is increasingly likely. Most importantly for the market narrative, the Fed is still tightening. If Europe and China ease and that in turn boosts global growth, the Federal Reserve will likely resume tightening. The divergence in monetary policy could power another bullish leg for USD. Finally, I still believe the euro is politically unstable and the final stage of this economic cycle will be deflationary/dollar bullish.

Correction or Bear Market? Find Out Soon

Earlier this year, I posted 2018: The Pivot Year. Coming into the year, many markets were poised for bullish breakouts if they weren't already breaking out. Massive inverse head-and-shoulders patterns on coal, steel and various emerging markets pointed to a potential inflationary breakout. Long-term bond charts signaled confirmation of higher inflation. On the other side of the argument, macro forces were arguing for a downturn. I favored the macro argument for deflation/disinflation and a downturn, but I had to respect the signal the charts were throwing off. Wrong or right, the year 2018 was going to shut the door on one of these scenarios.

One way or another, I expect action on trade in 2018.

Finally, the overall trend in social mood remains negative. I believe this is a higher order decline as in the 1930s, and thus dollar positive (deflation) rather than a correction and inflationary (1970s).

As I said above, I could be wrong. And the best case for my being wrong is still the commodities markets. Several funds such as steel, copper and coal (and related emerging market countries reliant on natural resource exports) are on the verge of breakouts. I expect China to slow, but FXI recently broke out above its resistance again and opened up 3 percent on Tuesday.

Macro proved correct. Slowing credit growth, slower economic growth, a stronger U.S. dollar and tumbling asset prices turned breakouts into failed breakouts.

Many are convinced this is only a correction and not a bear market. The reason is 2016, 2011, 2010 and 2009. Global central banks stopped a deflationary panic 4 times before and they'll do it again goes the bullish argument. Bears were burned each time, including in 2016 when it looked like a bigger decline was underway. In December 2015, I posted 1937 Redux: Deflationary Wave Has Returned. I was wrong then because I was focused more on the Fed and not global central bankers.

For the same reason I was mistaken about a large move in 2016, I believe this time is either a monster correction that will be aborted by central bank panic, or a bear market. Here's the global credit impulse from Saxo Bank.

Aggregate credit growth slumped in 2014 and into 2015 before turning up. Asset prices started wobbling in 2014. Oil plunged in November 2014. The yuan was allowed to devalue in August 2015. Global asset prices bottomed in January and February 2016.

Credit growth is a slow-moving leading indicator and bear market (correction) phases are short and brutal. It's always possible markets respond to other factors, but if credit growth is a key driver of global asset prices, it has yet to bottom, indicating global markets may not bottom until Q3 2019 at the earliest. That's assuming a central bank reverses policy. The Federal Reserve could signal a slower pace of rate hikes this week, but that doesn't do much for the market over the long-term. The ECB ended QE in December, as the Fed did at the end of 2013. Chinese credit growth is still slowing.

Back in August 2015, the month China allowed the yuan to depreciate, I posted: Shenzhen Home Prices Rise 20% in Three Months, Some Beijing Developers Hiked 10-20%, Each New Project Opens 5% Higher. I thought home prices were rising nominally ahead of a breakdown in the yuan, but it turned out it was a major burst of credit growth. In early 2016, China would layer on more stimulus to drive the market higher. A few months after global markets bottomed, I was posting articles such as Reform Can Wait: 4 Trillion Stimulus All Over Again as SOEs Pour into Land Market and Flour More Expensive Than Bread: Second Tier Land Prices Soar 180 pc and Ministry of Finance Owned Cinda Real Estate Becomes Land King. The seeds of a credit bubble were sown in mid-2015 and they were in full bloom by mid-2016. Starting in October 2017, China kicked off another major deleveraging effort. The last one started in 2013.

As that prior deleveraging wave was kicking off, I posted China Real Estate Rage Is Back; Ghost Cities Everywhere; Offshore Yuan Plunges; Talk of Falling Real Estate Prices Across China. In October of this year I posted: Real Estate Rage Spreading As Developers Grab Golden Week Opportunity, Will 2019 Be the Year of Defending Rights?

How do things look today in China?

iFeng: 专家：明年经济增速目标或下调 预计增速为6.2%至6.3%

Xu Hongcai, deputy chief economist of China International Economic Exchange Center, said that from the accumulated data, the economic operation is still stable. Judging from the figures in November, the current downward pressure on the economy is high. The economic growth slowed down in the fourth quarter, and this trend may continue into the first and second quarters of next year. The economic growth rate for the whole year is expected to be 6.2-6.3%.

That doesn't sound very pessimistic, but that's because it's translated through a propaganda filter.

More importantly, housing shows no sign of the reversal seen in 2015. Not only that, but prices have only plateaued. A decline in prices is ahead, not behind. China's NBS published November price data and it shows new home prices rose 1 percent nationally, with 63 cities reporting rising prices. Existing home prices fell in 17 cities.

iFeng: 楼市现拐点？连续两月超10城二手房价下跌

In November, the prices of second-hand houses in as many as 17 cities were down month-on-month, with Xiamen, Beijing and Wuxi falling by the top three, down 0.7%, 0.6% and 0.6% respectively.

In addition, the prices of second-hand houses in Hangzhou, Ningbo, Fuzhou, Zhengzhou, Tianjin, Guangzhou, Wenzhou, Jinhua, Shijiazhuang, Shenzhen, Quanzhou, Shanghai, Hefei and Haikou also fell to varying degrees.

Existing home prices rose 0.54 percent nationally, but those first- and second-tier cities are the leading indicator.

I've seen some arguing emerging markets will lead a bullish turn. The U.S. market has underperformed in the past couple of months, but that looks more like the U.S. catching-down to emerging markets.

If I can only have one chart and one asset, then it's all about the U.S. dollar. The broad trade-weighted U.S. dollar is less than 1 percent from its all-time high. The U.S. Dollar Index (DXY) is about 6 percent away. Long before DXY hits a new high for this bull market, the dollar will be at an all-time high versus global fiat currencies thanks to the rising share of EM currencies. Layer on my forecast for USDCNY to blast through 7 and its a recipe for financial market turmoil.

Given my poor timing ability, I would not be surprised to see a rally unfold into the New Year. Longer term, I expect Chinese economic data will worsen in early 2019, around the time of Spring Festival.

Here's one more chart that argues the decline is in the early stages: high-yield credit spreads. Investment grade spreads show a similar pattern. The only time a credit spread breakout failed to terminate at much higher levels was in 2005, when it was driven by an accounting rule change. Stories such as Leveraged Loans Are Looking ‘Scary’ to These Money Managers are reminiscent of the 2014-2016 correction's final stage, but spreads were far higher when funds such as Third Avenue Focused Credit shuttered.

If the "super bulls" are right and this is 2016 all over again, credit spreads and the U.S. Dollar Index (which hit a new 52-week on Friday) will turn down. Chinese credit and economic growth will pick up. Commodity prices will turn higher along with U.S. GDP growth, and interest rates will breakout to new multi-year highs. If the "central-bankers will save us" bulls are right, I'd wager the S&P 500 Index will have to fall another ~10 percent in the first half of 2019. A slow and orderly decline with low VIX and GDP growth above 2 percent won't spur the Fed. If the bears are right, the U.S. Dollar Index is heading above 100, possibly terminating at 120 or higher. The real pain for emerging markets and China hasn't begun yet.

A look at social mood points to either a short-term peak in negative mood or something much greater. The Yellow Vest protests in France continue and have spread as far as Canada.

Express UK : Macron's 'yellow vest protests' set to SPREAD WORLDWIDE - Egypt fear riots and CHAOS
CTV: Yellow vest protests spread to Canada, criticizing illegal immigration, taxes
BI: 70 yellow vest protesters detained after rallies spread to Belgium and the Netherlands

Brexit and Trump came at the tail-end of the prior downturn. Many of these protests (Egypt aside) have begun with major indexes only slightly off multi-year, decade-plus or all-time highs.

Finally, here's the S&P 500 Index and the Federal Reserve balance sheet, percentage change since the end of 2008 on the same axis. The S&P 500 tracked the rise in the Fed's balance sheet. It was in a trading range from the end of QE in December 2013 until the November 2016 U.S. Presidential Election. This time QT is underway. Since it began in October 2017, the S&P 500 Index has again seen virtually no gain (25 points, ~1% since October 31, 2017). In the absence of QE, stimulative fiscal policy and foreign central bank QE, stocks will at best tread water.

Universal Basic Income is the Bribe For You To Accept Totalitarian Control

This entire talk by Richard Werner is great, but the part transcribed below is a warning everyone should see. He explains the next and final phase of authoritarian control in under a minute.

The greatest concentration of central banking power is really the bit their aiming at, that's the central banks' goal. And, of course, digital accounts of dissenters and regime critics could be switched off, it would be very difficult to even purchase necessities. This is an Orwellian dystopia of total control, the end of any freedoms, that's really what central banks are aiming at.

Some central banks like the Bank of England have already prepared their microchip implant RFID chip to be implanted under your skin. And why the sudden discussion about Universal Basic Income from all the "grassroots" and inverted commas movements and billionaires. Universal Basic Income is the bribe for you to accept the microchip.

China is building a centralized digital currency with the ledger completely under government controls. They will implement it. It may be coming to the West as well. There will be more carrots and propaganda to make you think it's a good idea.

The future for the West is wholesale regime change, radical decentralization with political secession and a flourishing of smaller states or turning into China. The only difference between China and the West on current trajectory is China completed its revolution and has been pragmatic about keeping power since Deng in 1978. The West is still experiencing the unfinished revolution of 1789. China will peacefully transition into total authoritarian control, whereas the West will experience extreme turmoil because the outcome is as yet undecided.

BofA: Fed Will Hike

ZH: Bank Of America Reveals "The Next Big Trade"

In recent years, FX investors had to focus primarily on getting three key market drivers right: global risk sentiment, commodity prices, and which central bank will ease more and deeper into unconventional policy territory. Interaction between these three made life difficult for FX investors. However, looking back, these three can explain the biggest moves in the FX markets in the post-crisis years: the JPY weakening when Abe and Kuroda pushed with Abenomics; the EUR weakening when the ECB introduced QE after a long delay; the weakening of commodity currencies when oil prices collapsed; the strong CHF during the Eurozone crisis and when the SNB removed the EUR floor; and the EM rally during Fed QE and the sell-off when the Fed started QE tapering, to mention some of the most notable examples.

However, something fundamental has changed in the FX markets this year. Risk sentiment and commodity prices remain key market drivers, with China and oil prices in particular. But the market reaction to central bank policies has changed substantially.

Five G10 central banks have surprised markets with their policy easing this year, namely BoJ, ECB, RBNZ, Riksbank and Norges Bank, but their currencies are now stronger. With the exception of New Zealand, equities are also down for the year in these countries, which raises questions about the effectiveness of their monetary policies. In relative terms, the RBNZ was the most effective in weakening its currency, while the Norges Bank the least effective. A weaker currency may not be the main goal of monetary policy easing, but a stronger currency--and weaker equities--after having eased more than markets had expected is definitely a puzzle.

We have recently argued that markets have stopped focusing on what central banks are doing and are now focusing on what central banks may or may not do ahead.

If the BoJ or ECB suddenly called off their intervention, initially there's the shock reaction and likely rally in yen or euros, but then comes the reckoning. Does the currency rise or fall? Long-term interest rates? These questions don't need answers though, because it's theoretical. BofA thinks the Fed is among the most likely to tighten:

This suggests that inflation pressures and overheating are more likely to force the hands of the Norges Bank, Riksbank and the Fed to stop easing/tighten, while the ECB, the BoJ and the SNB are likely to retain a loose monetary stance and even ease policies more.

And the dollar bull market will resume with a vengeance.

Did Central Bankers Intervene to Prop Up CNY By Devaluing USD?

From STA Global: DID CENTRAL BANKERS JUST SAVE THE WORLD? (launches PDF)

In the following weeks, everything seemed to change when European Central Bank Governor Mario Draghi and Bank of Japan Governor Haruhiko Kuroda did something entirely out of character. Rather than pushing down on their currencies and driving the dollar higher, they appeared to intentionally disappoint foreign exchange markets and allow their currencies to strengthen.

When Janet Yellen and her colleagues at the Federal Reserve could have taken advantage of a golden opportunity to hike the federal funds rate (according to their policy models), they held steady, reduced their 2016 tightening projections from four rate hikes to two, and expressed continued concern for global economic and financial stability.

Perhaps Beijing threatened to free-float the RMB and unleash hell if major central banks continued to drive the US dollar higher. Perhaps they pleaded for an opportunity to avoid the unthinkable. But in all three cases, the European Central Bank, the Bank of Japan, and the Federal Reserve began to act in a way that weakened the US dollar, made it easier for China to manage its capital outflow dilemma, and supported a reflation in global commodity prices.

...Again, we’re watching closely for signs of more lasting intervention. But should this weak US dollar environment persist, we believe it may be favorable for equities, politically stable emerging markets, commodity producers, and midstream master limited partnerships (MLPs) in particular. If, however, policymakers are unable or unwilling to do what it takes to change the US dollar’s long-term upward trajectory, then all these pressures will likely return as the Fed hikes interest rates more aggressively in the face of growing inflation pressures. Until we see more signs of confirmation, we intend to move slowly and cautiously...

I remain long-term bullish on USD and bearish on yuan, but if global central banks successfully coordinate a devaluation of the U.S. dollar in order to avoid a large CNYUSD depreciation, this is a major step towards dislodging the U.S. dollar as global reserve currency because it signals the subordination of Federal Reserve policy to global forces, specifically China.

If central bankers have indeed enacted this strategy (skepticism is warranted for now), I expect the Fed will be panicking by autumn. Crude oil year-on-year comparisons start looking very inflationary starting in July, should crude prices climb into the $50 range or higher.

Whatever the case, right now I prefer to be long gold miners and short various assets. If the dollar weakens, the gains in gold mining shares should do as well as other natural resource producers (though it would pay to rotate out of Canadian and Australian miners and into U.S. miners). If the bear market resumes, the shorts will hopefully pay off and, if lucky, gold prices will hold up in foreign currency terms or even rise in USD as investors price in central bank intervention.

Is this the Oesterreichische-Kredit-Anstalt moment? Who gains from Cyprus?

In Similarities Between the Great Depression and Today, last updated in August 2011, I compared many bank failures and sovereign debt crises to Kredit-Anstalt, the bank failure in 1931 that unleashed the second leg of the depression by forcing Austria off the gold standard, and later the rest of Europe.

The usual suspects who are already upset about bank policies across the West and calling the Cyprus depositor tax a crossing of the financial Rubicon. However, Cyprus may decide to reject the plan and pushed back a vote to Monday.

To use a social mood example: almost everyone getting upset about the plan is already upset. Their mood is already negative towards the banks. If events in Cyprus trigger the tipping point that ushers in the next major decline in mood, it will be based upon whether the people on the margin swing to negative mood or consider this a different form of what has already been done to Ireland and Greece.

Are the printing presses firing up?

In posts in 2009 (Evidence of inflation?) and 2010 (You call this inflation?), I looked at actual Federal Reserve money printing. In a credit system such as in the United States, the Federal Reserve swaps Federal Reserve notes for debt, often U.S. Treasuries. Money creation is actually done through the banks, and the Federal Reserve creates the base money after the debt is first created by the private economy. When the system goes into deleveraging, debt is destroyed, either through repayment or default, and the Federal Reserve cannot stop the decline because it swaps debt for debt. Since 2008, the U.S. government has offset private sector deleveraging by running trillion dollar-plus annual deficits, which the Fed monetizes.


The Fed's 2012 New Currency Budget. As you can see from the second chart, while the value of printed notes is forecast to rise, it's not all that much in the scheme of multi-trillions in deleveraging and a low velocity. Furthermore, if you compare 2011's budget to 2011 actual printing, the Fed forecast a similarly sharp increase last year that never materialized, with the value of printed notes actually falling.

Turning away from the U.S., ZeroHedge noticed news that could indicate the printing presses in Europe may fire up: "Material Banknote Order Reinstated"

Fortress Paper Ltd. ("Fortress Paper" or the "Corporation") (TSX:FTP), announces that its wholly-owned subsidiary, Landqart AG, a leading manufacturer of banknote and security papers, has had a material banknote order reinstated. This order was unexpectedly suspended in the fourth quarter of 2011 which negatively impacted the financial results of Landqart's operations in the first half of 2012.

Shares of Fortress Paper gained 17% on Friday on the news. ZeroHedge comments:

Well, if the chart of De La Rue is any indication of how banknote printers respond to potential European disintegration, it just may be that the best hedge to a VIX soaring to 80, aka "disorderly Grexit" as explained earlier by Citi, just may be TSX:FTP.

This is yet to be confirmed, but this is they type of news needed to lead to inflation. The central banks cannot inflate by swapping debt for debt, they must create paper currency that survives debt repayment and default, in that way the money supply does not contract when debt is destroyed.

Nationalizing the European debt crisis: let's start talking about the EU breakup

The predictions of an euro breakup are widely found these days, but one still meets stiff resistance to the idea of an EU breakup. According to socionomics though, negative social mood will potentially lead to the breakup of the political union. One big step moving in that direction is financial nationalization of the sovereign debt crisis. In John Mauldin's letter this week, he notes that Greece was bailed out because the European banking system was filled with Greek debt. If Greece defaulted, German and French banks would go bankrupt and require billions in bailouts. Setting aside whether the Greek bailout will eventually work or not (it won't), consider what is happening to the sovereign debt of other nations:

Europe will then demand even more cuts when the targets are not reached (or increases in taxes on what's left of the private sector). Everyone realizes the party is over, but no one wants to be the first to leave. It simply will not do for the eurozone to expel a member. The precedent is dangerous. So they make staying in the eurozone so onerous that leaving eventually becomes the best choice (more on that later). "We didn't tell force you to leave; it was your own choice."

So what is happening now is that European banks are slowly shedding their foreign sovereign debt and buying the sovereign debt of their own countries. More Italian debt is coming home to Italy, Spanish debt to Spain, and so on. Given ECB funding, this process will go on for several years.

And at some point, if Spain or Italy decided to partially default, then European banks will be able to absorb the losses. If one of the peripheral countries does not get its budget in order, then it too will have to face the music of austerity and rolling recessions, just as Greece is, in order to get funding from Europe.

If, as an example, Europe decides to no longer fund Spanish debt (at the cost of German and other taxpayers) without draconian austerities, what then? Since Spanish debt will mostly be in the Spanish system (banks, insurance, pensions, etc.), if Spain decides to leave the eurozone it will be much easier on the larger European system.

I think the very fact of allowing (encouraging?) the various countries to bring the debt home to internal banks and institutions is in fact increasing the likelihood of exit from the eurozone, when a future crisis occurs . It's all well and good to talk solidarity, but continuing to fund the peripheral nations at the cost of other taxpayers, with the accompanying damage to the euro, will soon wear thin on voters in those other countries.

This is exactly as socionomics predicts would happen during negative social mood. What's interesting in this case is that this is a very political process. The argument for a euro breakup, but not an EU breakup, is that the political leaders are too invested in a united Europe and the people support it. Yet the nationalizing of debt is a very deliberate political strategy that allows each nation to act in its own interests. In the future, European nations will have an easier time ignoring problems in neighboring countries or acting in a purely selfish manner to "profit" at their neighbors' expense. Nationalism is more popular in Europe and now the ECB and financial system are making it easier to be a nationalist. Coincidence?

Europe is united?

Silvio Berlusconi angers France with Bank of Italy appointment

Sarkozy is angry that Berlusconi did not appoint an ECB member to the Bank of Italy, thus removing the chance for a Frenchman to take the spot, as was previously agreed in a deal that made an Italian the new ECB head.

Yuan weakens versus U.S. dollar

I mentioned some of the weak yuan arguments before, but now we're seeing a weaker yuan in action.
Yuan Forwards Fall on Concern Europe’s Woes to Delay End to Peg
The yuan itself isn't falling, just the non-deliverable forward contracts that are traded. They had been bid higher on the expectation of currency revaluation.

At the start of the year, I expected China to let the rising U.S. dollar do its work for it, rather than appreciating the currency on top of the U.S. dollar. I believed China would take many steps before using the currency option to fight inflation. Now, there's a chance that the solution for European Central Bank is to follow in the Federal Reserve's footsteps and print money, in which case Chinese exporters will suffer greatly as the euro tumbles towards parity. There is a case for revaluation in that China wants to gradually move towards a floating currency, but I do not believe there will be any change in the near-term.

Of course, the yuan might go down

Revaluing the Chinese yuan