Notes From Underground: We Won’t Be Fooled Again

I’ll move myself and my family aside

If  we happen to be left half alive

I’ll get all my paper and smile at the sky

For I know that the hypnotized never lie
                                   — The WHO
I’d like to follow-up yesterday’s blog post and the dilemma for the Fed in regards to low inflation and low wages, as in, which way will interest rates turn? Today the bond yields dropped in spite of a much higher PPI (producer price index), which measures wholesale inflation. If producers cannot pass higher input costs onto the consumer, profits will suffer. Tomorrow, the BLS will release the consumer price index, CPI, which is expected to be up 0.1 percent on the core and 0.3 percent on the headline number. If the data is higher than market consensus it will be interesting to see if the BONDS and NOTES shrug off inflation fears and continue the recent rally. The price of the 10-year note closed above the 200-day moving average for the first time in two months, even as the 30-year bond has been above the 200-DMA for the same period of time. The rally in the 10-YEAR NOTE acted to flatten the curve but I warn you, readers, that this curve is far from being flat by historical measures. Two-hundred eighteen basis points is far from being flat and again I remind readers that a year ago the 2/10 curve was a much flatter 145 basis points.

I wish to point out a piece written over the weekend by John Brady and Todd Colvin of R.J. O’Brien. In the note, titled, “The Food Input into April CPI,” they wrote: “We have discussed  in previous missives the effects of declining apartment vacancy rates on the Owners-Equivalent-Rent (OER) subcategory of CPI. We have likewise discussed the cessation of both Y/Y changes in fiscal policy restrictiveness as well as Medicaid cuts, both of which had previously put downward pressure on inflation readings. For example, within the GDP numbers we took note that Medicaid payments are up $37 billion Year/Year in the first 3 month of 2014, the highest increase on record. Finally, we have been taken by the continued strengthening of CRB Food Stuff index, which is 9.1 percent Y/Y.”

This is the onset of price increases that will pose such a serious dilemma for the FOMC, especially Chair Yellen. The FED says 2.5 percent inflation can be tolerated, but can any FED threshold be taken seriously? When the 6.5 percent unemployment threshold was violated the FOMC announced that the levels were not sacrosanct and would be interpreted with more qualitative analysis. The dual mandate will provide the cover for any decision the Fed makes to cast aside the possible restrictive policy to curb incipient inflation. Where the FED IS CORRECT is that rising prices with stagnant wages is a curb on final demand, especially with such a low national savings rate.

In a Bloomberg article yesterday, reporter Rich Miller notes that in Yellen’s May 7 hearing she said, “Most measures of labor compensation have been rising slowly–another signal that a substantial amount of slack remains in the labor market.” Yellen also told the Joint Economic Committee that she expected the labor participation rate to improve with a strengthening economy. (See, the labor situation is cyclical and not structural so inflation will not be a problem.) Supporting the FED Chief were former Bank of  England policy makers David Blanchflower and Adam Posen, who last month published a paper advising the Fed “to focus on labor compensation to determine the health of the job market.” The Fed’s dilemma has a dilemma indeed. Will the market’s be fooled again?

***From the song that I referenced from the WHO –the line at the end of the stanza posted above, I turn to Europe and hypnotic trance that ECB President Mario Draghi has the market under. Yes, sovereign debt yields across Europe have fallen to record lows, but what investors are buying all this debt on offer? First, it is the domestic banks of Europe buying vast amounts of their own nation’s debt so as to put their balance sheets in order ahead of the coming stress tests. Under Basel III, sovereign debt is deemed to have zero risk so a bank does not need to have reserves held against that asset class.

Second, global investors are searching for yield and the lower the yields on Italian, Spanish, Greek, Portuguese and Irish yields drop the more desirable they are to international investors. If the BONDS rise in value it means that the Euro crisis has been resolved and there will be no-default. Create a basket of the different sovereign debt and you can achieve an “attractive” riskless interest rate. Third, the recent strength in the EURO versus most major currencies, even in the face of Russia’s actions in the Ukraine, has convinced many global investors that the euro is a solid currency and can be a haven.

However, two issues lie on the horizon that will shatter the hypnotic state of investors. The May 22-25 brings the European Parliamentary elections. With low economic growth and high unemployment in most of Europe there is a great worry that radical right parties will attract great numbers of discontented voters who are not under the Draghi spell. The most important election will be in France where the candidate of the National Front, Marine Le Pen, has shown strongly in the polls. If Ms. Le Pen wins against both major parties this may actually force Mario Draghi into a response to provide a major amount of liquidity into the European financial system. More importantly, the French policy makers have been pressing for intervention to weaken the EURO by at least 10 percent to help the French economy, which is struggling under stagnant growth and high unemployment.

There is a Market News article from May 8 by Jack Duffy, “France To Push For Weaker Euro Despite Lack Of Support: Source,” and while I generally mistrust articles that are anonymous, the reporter does note two significant points. First, Economy Minister Arnaud Montebourg has “argued that a ten percent decline in the euro would create 150,000 jobs over three years and add 0.6 point to the French gross domestic product.” Also cited is a statement by the new Prime Minister Valls, who told a group of European socialists, “We need a major change that makes our monetary policy a tool for growth and job creation,a tool that serves the people.” The French have been clamoring for a weak euro policy and maintaining that if the ECB doesn’t cooperate that the onus then will be on the ECOFIN, which is made to act as a European Treasury Department. Some jurists maintain that euro currency belongs in the political realm and is not the jurisdiction of the ECB article 219 of the TREATY.

(To fully comprehend the turf battle consult your copy of the “ROTTEN HEART OF EUROPE” by Bernard Connolly. And, for those of you who care about your friends relatives and clients BUY A COPY FOR THEM so they won’t be fooled again.)

It has been rumored for the past two weeks that the Bundesbank has gotten behind Draghi and the ECB and provided support for some type of Quantitative easing program.Today, Bundesbank President Jens Weidmann delivered a speech and while i have not read the remarks in their entirety, the key points were reported by Alex Jenkins (Cantor Fitzgerald), with three points to note :

  1. Weidmann says Bundesbank hasn’t agreed to any new policies yet;
  2. Bundesbank would support ECB action if it’s needed; and
  3. Weidmann says France is operating at the edge of its means.
The last key point denotes that the German central bank is pushing back against French demands to weaken the currency. If the EURO were to weaken substantially because of ECOFIN directed intervention, German inflation would rise and the Bundesbank has its own mandate of battling inflation and protecting the German populace against any attack on its savings. Just some points to consider to remove the hypnotic haze.

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13 Responses to “Notes From Underground: We Won’t Be Fooled Again”

  1. asherz Says:

    Asset inflation backed by ZIRP is masking the underlying weakness in most global economies. High debt loads which are being sustained by bearable debt service (again because of low interest rates,not a long term phenomenon) are still impeding growth and employment opportunities. Germany will eventually succumb to the those looking to weaken the euro and Draghi’s QE will become reality. And with Abe doing his utmost to weaken the yen, with the yuan in a downward spiral, with the historically safe harbor dollar not breaking out to the upside even with the 10 year yield declining, with the early stages of competitive devaluations making its appearance, can stagflation in the long term be avoided? Central bankers can determine the outcome of the deflation/inflation struggle, with inflation being the preferred poison.
    With our national deficit slated to begin rising again in 2015 and the Fed monetizing that debt, where will the dollar trade looking ahead in the next two years?

  2. arthur Says:

    hmm… By the way, Mark Carney, governor of the Bank of England and head of the Financial Stability Board (FSB), was recently asked to identify the greates danger to the world economy. He chose shadow banking in the emerging markets, a.k.a, China.

  3. yra Says:

    Mark Carney is a very bright man—wish he would stop trying to talk the Pound down because he does not have the magic of Draghi

  4. arthur Says:

    Currencies matter—yen, euro, dollar, renmimbi, pound—it creates winners and losers.

  5. yra Says:

    Arthur—at times very true–while in other environments not so much and that is what makes it so difficult in a zero rate environment

  6. Bob Johnson Says:

    The EUR/USD is definitely going lower. A confirmation of this will be when we break the 200 day at 1.3626. I prefer to be long of USD/CHF. Citi-tech today put out a trade recommendation to buy USD/CHF around 0.8950 with a stop at .8800. We have had this trade on for a week.

  7. joe Says:

    “Where the FED IS CORRECT is that rising prices with stagnant wages is a curb on final demand, especially with such a low national savings rate.”

    At least we know the Fed can still define stagflation, however nuanced, and loath to say it.

  8. Chicken Says:

    “global investors are searching for yield and the lower the yields on Italian, Spanish, Greek, Portuguese and Irish yields drop the more desirable they are to international investors.”

    I’m not sure I want to buy an expensive currency and an expensive debt simultaneously, maybe if I owned it already I would consider taking my gains? such as perhaps one last hurrah into temporary strength?

    • joe Says:

      like any other instrument of finance, today, they just figure they’ll trade it. Who “invests” anymore?”

      • Chicken Says:

        We cannot invest anymore unfortunately, b/c our losses won’t be socialized.

  9. yra Says:

    Chicken–that is why you are trader/investor–because value matters and that is how I trade but pension funds,insurance companies and other “institutional ” investors have to join the party when I am getting ready to leave—-but you are point right on –and remember Rich Dennis’s famous piece on the slower fool theory

  10. Alex F Says:

    European banks would rather repay their outstanding LTROs than hold cash reserves as they begin to get negative rates on deposits. It’s hard to say whether this is driven by the risk of negative depo rate or general volatility in repayments though.

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