Notes From Underground: The Week That Was …?

What a week last week turned out to be (and that was if you just followed the headlines). Tariffs are taxing the global financial markets as they try to guesstimate the economic impact from the effect of tit-for-tat responses to the initial U.S. measures efforts to gain support for dealing with Chinese trade violations. The FOMC added to market volatility as the suspense over three or four rate hikes still impacts the DOT PLOTS. The Bank of England confused markets as they voted 7-2 to sustain the current interest rate policy, even though consensus assumed a 25 basis point increase. By week’s end the confusion reverberating around the globe did serious damage to equity markets as the S&PS were down almost 6 percent on the week and the European stock indices continued their continued their selloff, making them the weakest of all regions (in contravention to the punditry’s call for the buying of European stocks).

What is the genuine catalyst for last week’s equity selloff? It is difficult to isolate the single variable, but as always, I caution that DEBT, DEBT, DEBT is a significant element, especially when the central bank of the world’s largest debtor is reining in liquidity, while raising rates and shrinking the balance sheet. Even as equity markets sank, U.S. Treasuries failed to realize their haven status and remained virtually unchanged. Correlations are breaking down.

***The G-20 meeting of finance ministers did little in offering solutions to the problems of currency manipulation or tariffs. In its communique, finance ministers and central bankers offered the usual: “Flexible exchange rates, where feasible, can serve as a shock absorber. We recognize that excessive volatility or disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will refrain from competitive devaluations,and will not target our exchange rates for competitive purposes.” This is more nonsense for it fails to recognize that exchange rate values are frequently mentioned as reasons not to raise interest rates: The RBA, RBNZ, ECB, BOJ, and, especially the SNB, mention the value of their currencies as a possible headwind.

Central bankers absolutely use negative real yields as a tool to keep interest rates lower than mandated by their own economic models. Failure to acknowledge these outcomes fuels the flames of tariffs as proposed by the Mnuchin, Ross and Navarro in the White House. It reverts back to the claims of the National Association of Manufacturers, especially the words of former Ford CEO Mark Fields: “Currency intervention is the mother of all trade barriers.”

***There was an important piece published at Project Syndicate from noted German economist Hans-Werner Sinn. In the article, titled, “Europe Should Not Retaliate Against U.S. Protectionism,” Sinn said the Europeans should not “throw stones when one lives in a glass house.” Europe has been a high import tax economic system for several decades and the professor is forthright in noting the high import duties for agricultural products. Sinn is honest to note: “From the beginning, the European Economic Community was shaped by a bad compromise between Germany and France: French Farmers could charge excessive prices, and Germany could sell its industrial goods to France.” The imposition of high agricultural import duties has resulted in European consumers paying much higher prices for food. Again ,nothing is as easy as portrayed by those pursuing a preconceived narrative to suit the established agenda.

The world is a very complicated system fraught with all types of inconsistencies fostered by long-held positions of self-interest. Our work is to pierce the veneer of the status quo and look for investment opportunities as the world system enters a new realm of instability. The rise of uncertainty is causing the breakdown in previous established correlations. Breakdowns of established patterns leads to increased volatility across a myriad of asset classes. 2+2=5, indeed.

***Building upon the uncertainty principle that was exacted from last week’s turmoil, on Monday the euro currency rallied even as the news out of Italy led to a selloff in the Italian bond futures and weakness in the European equity markets. The EURO is the most perplexing of all currencies for as I’ve noted many times, the political situation in Europe is unstable and its interest rate policy is to keep real yields negative in an effort to sustain the fragile growth the EU is experiencing. Last week, the EURO was weak on several of the crosses– euro/pound and euro/yen. As U.S. Treasury Secretary Mnuchin calms tariff scares and the Chinese are pushing a negotiating agenda, some of last week’s cross-rate activity is being unwound. However, we must be very aware that the EURO may be signalling far greater problems with the dollar, reflecting what investors feel is a White House desire for a weaker dollar.

Many questions are raised but few are answered. In a February 28 Project Syndicate piece by Carmen and Vincent Reinhart titled, “The Fed Should Be Careful What It Wishes For,” the economists offers up its critique as to why the Fed gets inflation wrong. The Reinharts cite what has been a long-held view of Notes From Underground: “The summary may have inadvertently revealed part of what the Fed has been getting wrong. The description of its efforts to determine inflation, with its blinkered focus on the domestic economy,is a throwback to the 1960’s. [The summary was a direct reference to the minutes of the January FOMC meeting]. Nowhere among the thousand words were the phrases ‘trading partners,’ foreign exchange value of the dollar, commodity prices or global supply chains to be found.”

The message to the FED is that models are deficient in being solely reliant of domestic data. The Project Syndicate warns that the “rest of the world exists.” Since the Phillips Curve or Nairu have been adopted as gospel, certain economic relationships have changed dramatically:

  1. Total U.S. import and exports have grown to 30% of nominal U.S.GDP, three times the amount since Camelot;
  2. U.S. GDP as a percentage of global GDP has dropped to 25% from 35%; The Reinharts noted that the “rest of the world is bigger”;
  3. U.S. trade relations have substantially changed from being old-world dependent to being much more involved with Asian and Latin American economies, which have large pools of lower-wage workers. The FED misses its inflation targets as it relies on outdated models. The caution from the Reinharts is that as these models miss the downward pressure due to global forces if global growth accelerates dramatically the FED could find itself way behind the curve because of flawed modeling.

As usual, we have much to think about. I suggest readers search out the Stephanie Pomboy interview in this week’s Barron’s. Pomboy succinctly states many of the issues that have been discussed in NOTES FROM UNDERGROUND. More to follow

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11 Responses to “Notes From Underground: The Week That Was …?”

  1. BenjaminIs replies to: Money Flow Trading Method along with Risk Management - Forex trading for everyone Says:

    […] https://yragharris.com/2018/03/26/was/ […]

  2. David Richards (@djwrichards) Says:

    Simply put, IMO capital flows are driving currencies and interest rates don’t matter as the Euro, Yen and even the Yuan soar on their continuing unwind of US investments for greener pastures abroad.

    Perception matters more than reality. And Europe appears to be more politically stable than the US. And who knows, perhaps it is currently, with a possible US presidential impeachment battle ahead and the Weimer Triangle (Germany, France, Poland) potentially re-emerging as a salve for the EU. But are these already priced in?

    Technically, I expect a significant correction in currencies’ strength against the dollar sometime this spring/summer before the next shoe drops for USD. If so, the corresponding spike in the Euro will eventually lead to its next economic and existential crisis, by which time the Trump circus will be out of town and the US might again appear to be the more stable of these two clown shows.

    • yra harris Says:

      David—what you say certainly makes sense and I read the piece on the Weimar triangle but I think that outcome is FAR from certain.Macron is overplaying a weak hand and pushing for a solution that will cause political angst in Germany,Netherlands,Finland and Austria.Tonight the FT has a story about Brussels skimming the ECB “profits” to make up shortfalls in the EU budget–stay tuned.

  3. Bob Zimmerman Says:

    Yra just what if Trump succeeds and gets the trade deficit down doesn’t this mean a higher dollar? The Fed would not be inclined to raise as fast. The stronger dollar would also bring more money into the US Stock Markets. Kudlow=King Dollar?

    • yra harris Says:

      Bob–if the deficit gets reduced because of the U.S. going into recession the the Dollar may not rally as the Fed will panic because of fears of a deflationary spiral set in motion because of the massive amount of debt overhang.If the deficit goes into a precipitous fall because of growth around the globe picking up and demand for U.S. exports increases then the Dollar will rally at some point as the Fed raises rates as rising foreign demand puts pressure on U.S. capacity—outcomes are far from certain

  4. Stefan Jovanovich Says:

    The same commentary could have been written about Great Britain in 1840 about the economic rise of the Russian Empire and the revival of France. Indeed, it was – even as the Corn Laws were being discarded, The gospel of the Triffin dilemma will remain holy writ in academia and elsewhere for the same reason the importance of a country’s reserve currency status does. One needs the morality of the old time religion to be able to scold the present for being so different. So, as Libor gives way to SOFR and there is the opening of a yuan-denominated market for oil, the dollar demonstrates its further inadequacy by being just another monetary denomination.

  5. Ronald Ferrill Says:

    Interesting commentaries after the post! I am not as erudite, but one of those “Yanks” that others, who went to the right schools and were ordained into senior ranks of executive power would wonder at my relative insights into how things work. In this time, I believe that rates are reality, especially how they interrelate and move toward possible inversion (we’ll see how reality bites if that happens), and also that the dollar still matters. Why? Well, I don’t watch the news on TV, and am somewhat inured to the nonsense of popular news, while in the meantime, Mr. Kudlow and Mr. Bolton are serious players in a serious world. Today’s (last night) points by China that they don’t want a trade war with U.S. is sensible and just a nod of understanding to this minor point President Trump is letting them know he gets. His man on trade Wilbur Ross has worked with/in China for many years and understands the game.

    What I notice (gleefully) is missing in the Trump white house are the scads of ring kissing elitist never-worked-really academics and nomenclatura. Dollah will do just fine, and like any true capitalist, I know that my $$ don’t matter much in the big picture, so just keep trying to multiply them.

    My prayers for during this holiest of weeks. Be safe, think of our insignificance yet total importance in God’s creation.

    • Robert Sypniewski Says:

      Your last 2 sentences are beautiful Ronald and I needed to read them reminding me that this is a holy week. Thank you

  6. David Richards (@djwrichards) Says:

    Project Syndicate also has a new piece today by the World Bank chief economist entitled “High Tariffs On Chinese Imports Will Weaken America”, explaining how “China’s imposition of tariffs on imports from the US would thus have a bigger impact on US producers than vice versa”. As Stephanie Pomboy above pointed out, US consumers aren’t in good shape. So imposing a broad tariff tax on fragile consumers, who account for 70% of US GDP, could be an effective way to crash the US economy.

    Another PS piece new today entitled “The Dark Matter of Trade” explains that the US actually enjoys a US external trade deficit of zero taking into account services and knowledge industries, rather than simply physical goods. It similarly explains how US trade tactics are likely to seriously shoot itself in the foot. If, for example, more countries adopt the new EU plan to start taxing the likes of Google and the already-troubled Facebook, whose users are more than 90% located outside the US.

    Thus for example the high flying FANG sector might be setup for a serious market correction triggered by a bad new US trade policy. Which would cause collateral damage in all kinds of sectors and industries, such as for example the high-flying real estate markets in Seattle and the Bay Area.

    We may have our fundamental backdrops for the technical setup of a potentially significant correction to US equity markets over the next several weeks.

    • Stefan Jovanovich Says:

      One could hardly expect the World Bank to say anything else. The religion of “free” trade is now a universal faith. What puzzles me is how the slight amendments to the catechism being made by the U.S. qualify as mortal sins while the WTO’s wholesale dealings in “most favored nation” indulgences are seen as acts of continuing piety.

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