Monday, June 27, 2016

The Real Crisis Brexit is Uncovering

BREXIT is sexy and fun, well parameterized so folks can chew it over and make sage proclamations.  And no doubt the market was rocked, with a SP500  1999 print at the lows last night from a night session high SP500 2025  as "Remain" high confidence made some hedge funds feel there was an easy harvest to be had by jamming the market upwards.  But as results came in no doubt the senior guy who ran the desk or even the hedge fund owner ordered all their folks to sell the SP500 and take their hit, perhaps even being told to not bother showing up for work this morning.  
But BREXIT is in reality a rather small event in terms of flows and company valuations.  Contracts will be honored and crates of olives from Greece will be paid for once they reach London and the boat load of Bentleys off to Poland will still be delivered on a timely basis.  No labor unions will have an incentive to strike, no tires will be burned and unless you are a migrant Uber driver in Paris - no harm no foul but for your usual risks being beat up by 3rd generation Pied Noir cab drivers who have completely forgotten that their dad or granddad was in your situation not that long ago.The Byzantine European Council will still go on and folks still nap in the European Parliament.  Tusk still is the President and Merkel wont gain or lose any votes.  

So why the excitement?  

It became a game where everyone agreed to bring their betting slips and play hard upon the vote.  But it is really a non event.   

Now I could dig deeper and discuss the Habermas Adorno form of democracy, the "deliberative democracy" is under the gun, but it is long spiel, and while I find it critical few do so I wont go over it now.  So I will let Nigel Farage do the explaining - he is more fun to listen to anyway and I am happy for him now as he chortles away.  
Markets will sort out and as it quiets down I wont be surprised to find Cameron states he thought he was clear that he meant October 2017 as his end date and the Article 50 wont be required to be filed until that time.  Lots of exclusive dinners in Brussels and lots of perks yet to enjoy.

But what is being uncovered is an extremely dangerous situation. First the lack of surprise, not the outcome but that the event was going to happen, has allowed the world's  central banks to make important phone calls and meetings to act in unity and in coordination.  All to the good one would think, but it is not the role of the world's central bankers, no matter how comfortable with each other, to put into place foreign policy for their governments.  In fact that this is not a surprise which make this all the more worrisome.   

As the world's central bankers use this event as another affirmative "club" ceremony, they become more entrenched and assured that the identical policy they are all applying is the correct and only way to go about things.All the world's central bank, with many able to now go into negative rates, have become convinced that the Wicksellian idea of a "natural rate" exists such that to place the central bank rate (in the US it is Fed Funds) below the "natural rate" one is stimulating the economy and if you place the rate over the "natural rate" then you are tightening the economy.  That if one is below the "natural rate" for long enough you will raise inflation and by the way improve the lot of your citizens.  That if inflation is not rising then you are simply not low enough and the "natural rate" is lower than you think.
And they trust in the inherent efficiency of the markets (and though they  prefer to never discuss it, the equity market especially) so that if markets trade south it must also mean that rates are not below the "natural rate", so they lower rates.  Therefore all that is given heed is the rate of inflation and the stock market - nothing else counts like retail sales or employment or home sales.  They are all furiously set to drop rates to any levels, especially now that the way is shown to go negative rates. So BREXIT is welcomed by Yellen as the drop in the SP500 and the turmoil allows her to "reluctantly" shed normalization and get back to figuring out when and how much to ease if not go to negative rates. 
This is a disaster for in truth there is no "natural rate", that Wicksell works fine when rates are well over 3% or 4%, but are a myth if not a fallacy as rates are in proximity with 0%.  In fact at some point - most see it at around 2% or lower - the so called natural rate and the Fed Funds rate become one and the same and that the reduction of Fed Funds will reduce inflation and will in fact be a depressant on the economy - Allie through the Looking Glass stuff.  Things are not what they are when played on the Blue Guitar.  This is in fact a cheeky explanation for the NeoFisherism school of monetary policy which says that once certain equilibrium points are breached, the central bank must raise rates to raise inflation and to be stimulative.  

Obviously if NeoFisherism is right this could end as a disaster and while in the end the reality of the search for corporate profits will prevail, in the meantime Yellen's Fed could produce a "lost decade" just as Japan experienced.  NeoFisherism is based upon the "Fisher Rate" (why the name) which acts like a portal from the central bank's rate setting policy to the growth (or decline) of the nation’s GDP.  That there is no "natural rate" just that the Fed Funds rate is equivalent to the Fisher Rate which is equivalent to real GDP plus inflation.  So raising Fed Funds raises real GDP and NGDP in units of NGDP, and a drop in NGDP will drop the Fed Funds rate.  That everything is malleable and coordinated.  

i = GDP + inf.  

If one is on the lookout for the Fisher Rate one can derive the rate form various maturities and then start to compare to various other assets that in the end are dependent on their setting of the nation's GDP.  This is the Origin of all return and why we call our process the 'Origin" - the "Origin Process".

So if the central bank is in error using ancient Wicksell ideas of a natural rate, a rate that doesn't exist, then the central bank - especially if the central bank is powerful, and in the end not have the Origin of the economy, its NGDP, but actually have the Federal Funds rate price the NGDP. And if an event like BREXIT comes about and gets the central bank all fired up, then as they are now - from their perspective - completely justified in taking extraordinary measures and drop rates, now into negative levels, to whatever works until inflation rises and economy is revived.  If NeoFisher rates are the right way to look at life this never happens and if powerful enough the central bank will at best cause a "lost decade" or perhaps even a depression. At the head of this note is SP500 (the SPYDR) in a scatter plot versus the implied NGDP expected in 7 years (which is tricky to mine in the markets and worth your price of admission to take me on as your money manager just for that alone) which shows that as Yellen goes slow or now even avoid normalization those Bloomberg odds of a rate rise by December, say, is also pricing out the odds of a depression.  
If the SP500 were to take implied NGDP to heart, and see a high likelihood of a lost decade ahead, were to occur then SP500 would price toward 1200 to 1400 level.  And of course this is what happened to Japan after then first up trade in the N225 during the early part of the 1990s. So BREXIT might be the rather minor event which triggers the resolution of the real problem, the massive error in policy that the Federal Reserve is now committing.  The right way to read this is via the Fisher Rate lenses where the forward Fisher Rate is the forward NGDP forecast.  The US simply cannot survive politically if the Yellen Fed are to carry on insisting that the potential NGDP in the USA is, around or less than 1%.  Certainly the SP500 will not be trading where it is now if that is so.  

Since I do not think this is what the US will do, then I am also saying Yellen must go, US Treasury 5 years must go to around 5% and Fed Funds normalize.  Or Yellen figures out how to duck the righteous Bullard attack and adopts with honor NeoFisherism ideas.  This likely means she has to replace the Board of Governors economic staffers and dash her relationship with Princeton and Woodford crew.   I do not  think she can.

The immediate tactical problem is that given the above the US Treasury market is "blown" as the usual and correct offset in providing the offset to risky assets selling off.  While this may seem trite, it is not when the portfolio management problem is the Met Life balance sheet, or the Texas Teachers retirement portfolio, or Norway sovereign fund.

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