Fed up. In Italy ...

The Federal Reserve is up to bat again today. And it seems the bets on tapering are rising with each passing moment.

Let's just say I'd be surprised if they announce tapering today. I have several reasons why, but let's just say the state of things in Italy is on the Fed's radar screen.

As it pertains to tapering expecatations, we've provided thorough details and analysis in recent issues of Global Investor (for paid members only.) But let me summarize a few pieces with broad strokes:

 

 

  • Inflation is not pressuring the Fed to change policy
  • Potential adverse global market reaction to a perceived change in rates is pressuring the Fed to sit tight
  • Further, tapering could counteract the influence of Japan's Abenomics which accomodates a renewed yen-carry trade
  • The adoption of the Volcker Rule creates new uncertainty in the US financial system
  • The fragility of the European financial system has become heavily dependent on Fed activity

 

 

I think most of those items are self-explanatory. But let me update you on the latter ...

If you don't regularly read Ambrose Evans Pritchard in The Telegraph, you should. He's very thoughtful and very critical. And his focus tends to be on the Eurozone. (Note: As good as Pritchard is, try not to let his analysis dictate your trade timing. It doesn't work even when it sometimes feels like it must!)

Anyway, he had a piece published yesterday: Italy’s president fears violent insurrection in 2014 but offers no remedy

And here is the crux of his piece, questioning why Italy is in the crummy predicament to which its President admits:

Now why might that be? Might it not have something to do with the central overriding fact that Italy has a currency overvalued by 20pc or more within EMU: that it is trapped in a 1930s fixed-exchange system run a 1930s central bank that is standing idly by (for political reasons) as M3 growth stalls, credit contracts, and deflation looms?

And later he goes on to say:

To those who keep insisting that Italy should tighten its belt and claw back competitiveness by cutting wages, I would contend that this is mathematically impossible in a climate of EMU-wide deflation or near deflation.

The reason should be obvious to everybody by now. You cannot allow the nominal debt stock to rise on a shrinking nominal base. Such a policy causes the debt trajectory to spiral upwards. Italy’s debt has already jumped from 119pc to 133pc of GDP in the last three years in large part because of the fiscal austerity policies.

Yeah, it should be obvious. But that doesn't mean it won't continue to be ignored ... by Germany.

One may be inclined to think the Eurozone is on the mend just like the US, just behind the curve a little bit. We hear all kinds of things about how valuations in Europe are attractive. But I'd argue that assumes a lot for the Eurozone's growth future. I think "attractive" valuations are also relative, i.e. how European markets stack up to US markets. (Doug Kass recently stated he thinks US markets are 8 to 10 percent OVERvalued.)

The biggest threat to Europe-on-the-mend is political and social discontent.

Germany this week launches its grand coalition, a deal between parties on which direction to take German policy. And it's not been met with kind words. From The Telegraph:

“The agreement does not contain anything that would solve the European debt crisis, re-ignite growth in the euro periphery, or dampen the disastrous impact of austerity,” said Sebastian Dullien from the European Council on Foreign Relations in Berlin.

Prof Dullien said it had blocked a viable EU banking union and left in place the “toxic vicious cycle” between weak banks and weak sovereign states, each at risk of pulling the other down.

Geez. What more is there to say?

Alright, since you praise my every utterance, I'll explain what this means in my own words:

Germany will not be making any changes that meaningfully impact the Eurozone dilemma in a positive way.

And guess who isn't going to like that? Perhaps the rest of the eurozone, maybe? From an older Pritchard article:

... the new plan of Romano Prodi, Italy’s former premier and “Mr Euro”. He is now calling for Italy, Spain, and France to band together rather than deluding themselves that they can go it alone, and to “bang their fists on the table”.

Nobel economist Joe Stiglitz echoes the theme at Project Syndicate. “If Germany and others are not willing to do what it takes – if there is not enough solidarity to make the politics work – then the euro may have to be abandoned for the sake of salvaging the European project,” he said.

Frankly, nothing is going to get done in Europe anytime soon. 

The best they can hope for is a perpetually effective perceptions management campaign led by the European Central Bank's own Mario Draghi. His strategy (similar to most policymakers of the last few years) is to air some of the eurozone's dirty laundry (namely, vague concerns for Eurozone growth) so markets feel like they're in the know.

But regardless of the "disclosures", if the markets get blind-sided by what's really preventing progress in the eurozone economy, they'll get spooked quickly.

And one more blurb from a different Prtichard piece:

“Every 10pc rise in the euro costs France 150,000 jobs,"said Montebourg. "Britain, the US, Japan, all have a strategy of monetary stimulus, but in the EU we have nothing but hard money and hard budgets. The currency doesn’t belong to bankers, and it doesn’t belong to Germany, it belongs to all members of the eurozone, and we have something to say about this,”

Is that a threat to invoke Article 219 of the Lisbon Treaty giving EMU ministers the final say over the exchange rate, a power that lets them dictate monetary policy by the back-door, provided the Commission plays ball?

A Deutsche Bank study said the euro “pain threshold” for Germany is $1.79 to the dollar. It is $1.24 for France, and $1.17 for Italy, a staggering difference. The euro ended last week at $1.35. This means Germany is sitting pretty, and it is Berlin that dominates the policy machinery.

Yes, indeed -- the US has a strategy of monetary stimulus. And the arbiter of that stimulus is very mindful of the situation in Europe and its potential contagion effects if Fed tapering sparks a rethink in markets.

Tapering rhetoric shocked markets when first broached in May. At most the Fed will test out the rhetoric again today so that they may see how markets react. But ultimately they are stuck because they've generated a global "wealth effect" dependent upon monetary stimulus.

-JR Crooks

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