The Battle of Battles, Central Banks vs. Deflation

January 22, 2015 will see  this battle coming to a head.  The volatility that we have seen this week will no doubt continue until the last week of the month.

At the beginning of each year I like to look at the surprises for the coming year forecast by two people.  Doug Kass of Seabreeze Partners and Byron Wien of Blackstone.  Doug has a good view of contrarian possibilities and Byron is a good gauge of establishment thinking.

You can google the surprises that each have outlined.  This year Byron did not really have a surprise that rates discussion, kind of surprising that nothing jumped out, just more of the same that you can read in print or online every day.

On the other hand, Doug’s thinking really points out some possible surprises, 15 of them, my favorite, although I have reservations concerning his gold forecast, is listed here:

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

“Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth.” – Jeremy Grantham

“The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine.” – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won’t permit a more aggressive strategy. Markets are disappointed with the small size of the ECB’s initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can’t get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn’t accelerate and inflationary expectations don’t lift). 

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium-sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can’t fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do “whatever it takes,” but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country’s president. 

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign. 

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world’s central bankers in general, and the Fed in particular, once again has taken us down an all-too-familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers’ balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets. Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate in to a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi’s jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region’s financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world’s stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015.

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