Notes From Underground

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

Tags: dot plots, EU, Euro, Fed, FOMC, G-20, models, NAIRU, Phillips Curve, tarrifs, trade

This entry was posted on March 26, 2018 at 7:57 pm and is filed under Central Banks, Europe, Fed, trade, United States. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.