Thoughts from the Frontline: Merkel Opens the Gates

“The European Project has very little economic and political capital left to defend it if anything goes wrong now. As Mr Juncker says, the bell tolls.”
– Ambrose Evans-Pritchard

Perhaps I should issue a storm warning for this letter. Maybe it’s because I had major gum surgery on my entire lower jaw this week and am in a bit of discomfort, but as I read the news coming through my inbox, it’s not helping my mood. This week’s letter will focus on the immigration crisis in Europe – after I muse on what I think is the very disturbing aftermath of this week’s Federal Reserve meeting.

It wasn’t a shock that the Federal Reserve did not raise rates. Even the most inside of insiders said the odds were at most 50-50. Those Wall Street Journal reporters who have an “inside ear” at the Federal Reserve all indicated there would be no rate increase. The IMF and the World Bank were pounding the table, declaring that it was inappropriate to raise rates now, and although most FOMC members give lip service to the fact that Federal Reserve policy is to be based solely on domestic considerations, global concerns may well have played a role in their decision.

What surprised me was the aggressively dovish stance taken by Yellen in her press conference and in the press release. It would have been one thing to come out and say, “We’re not going to raise rates at this meeting, but conditions are getting better, so get ready,” so that the market could have a little certainty. The statement we got instead, combined with early data from the quarter, is making me rethink my entire view on the timing of an interest rate increase.

  My immediate reaction upon reading the press release was almost perfectly echoed by my good friend Peter Boockvar of the Lindsey Group):

The Fed punts AGAIN on a new set of excuses, and I'm sorry to many

The Fed punted AGAIN and thus are inviting us to the daily obsession of when they eventually will hike for another 6 weeks. While the economic commentary on the US was not much different than the last statement, they added “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” They see the risks to the outlook for economic activity and the labor market as nearly balanced but [are] “monitoring developments abroad.” Jeff Lacker is the only one that stood out from the crowd with a dissent and the desire to raise 25 bps.

Bottom line, the problem now is not when the Fed will raise rates or not, it is the paralyzing discussion about when they will eventually raise rates. We get to do this all over again as the Committee continues to day trade every data point not only in the US but now globally. They are the center of uncertainty and the multitude of excuses over the past few years has reached a tipping point that I don’t believe the stock market will continue to embrace. China has been slowing for 5 years and commodity prices have been falling for 4 years, and the Fed has now discovered them as risks to their outlook. Are we going to now price in the greater chance of a rate hike if China’s PMIs start to improve, if retail sales tail higher?

The Fed is implicitly acknowledging again that their policy action over the past 5 years of putting the US economy on a sustainable growth path has been a failure and now if their international concerns become more pronounced, they will also admit to the world that they have no tools to deal with it. I think today’s decision was a bad one. The dollar rally should be over and I’m bullish on precious metals (again) as I don’t understand at all what the bear case is in it anymore. Other commodities should benefit too from the weak dollar.… Therefore be cautious, the Fed did more damage to its credibility today.

Lastly and sorry to speak from my soap box to those who don’t care to hear it but, I’m sorry to the retirees that have saved their whole lives. I’m sorry to the generation of young people that don’t know what the benefits of saving [are]. I’m sorry to the free markets that best allocate capital. I’m sorry to pension funds that can’t grow assets to match their liabilities. I’m sorry to the successful companies that are competing against those that are only still alive because of cheap credit. I’m sorry to the US banking system, [which] has been hoping for higher interest rates for years. I’m sorry to those industries that have seen a pile of capital (aka, energy sector) enter their industry and have been or will see the consequences of too much capacity. I’m sorry to investors who continue to be bullied into making decisions they wouldn’t have made otherwise. I’m sorry for the bubbles that continue to be blown. Again, I’m sorry to those who don’t want to hear this.

What he said.

Granted, the global economy is slowing down. But Stan Fischer (Fed vice-chairman) gave an extremely strong speech not all that long ago, saying that the US Federal Reserve was focused only on domestic concerns. We just printed what might be the highest GDP number for the second quarter that we are likely to get for some time. Nobody is happy with the way the unemployment number is working out, but 5.1% and falling isn’t shabby. This is a slow-growth recovery that probably typifies the New Normal, so to expect to find an economy hitting on all cylinders before you normalize rates is not realistic.

This Fed, massively dominated by academic Keynesians, has demonstrated that the conditions for normalizing rates are far more stringent than many of us had been led to believe from the speeches of the FOMC members themselves. This is a Federal Reserve with hundreds of staff economists who create numerous models to guide their actions. The fact that none of these models have been anywhere close to right for decades should give us pause. Indeed, in her press interview Yellen admitted that the models don’t appear to be working.

We have a Federal Reserve that doesn’t trust its models and is running US monetary policy on its understanding of a flawed academic theory.

We’ve discussed in this space why these models don’t work; it’s because they’re based on a theory of economic organization that is fundamentally flawed and doesn’t reflect the complexity of the billions of economic reactions by participants in the marketplace every day. The only way the Fed can build a model to describe such complexity is to assume away the real world – to impute market motives and relationships based on their imperfect, academic understanding of how the world works.

Where are we? It is likely that before the December meeting we are going to see third-quarter GDP come in markedly lower than second-quarter GDP. If we are now focused on the global economy, as the press release suggested, that is also likely to be weaker. Inflation, at least the way the Fed measures it, is unlikely to be an issue. In this environment, will they raise rates? I now find that doubtful unless we get some remarkably boffo data points – which would be a surprise.

Going into 2016, a presidential election year, unless the US and global economies surprise to the upside, do we think we will see rate increases? It is now quite possible, it seems to me, that the next significant move by the Federal Reserve will be to initiate QE4 when the economy once again weakens or dips into recession. Remember, there is always another recession. The business cycle has not been repealed by leaving rates at the zero bound! Yes, I know that the Fed’s own research shows that QE was ineffective, but that will be one of only two weapons they still have in their arsenal. The other is negative rates, and I doubt they will start out with negative rates unless we get more than a garden-variety recession.

As Peter noted above in his final paragraph, the Federal Reserve has changed the fundamental equations of how investors, savers, and businessmen interact with each other. The Fed is distorting the essentials of the market. It is one thing to acknowledge that rates are likely to remain lower because we are in a disinflationary/deflationary world and will be for some time; it is another thing altogether to leave rates at the zero bound. One can make the case for lower rates and QE at the beginning of the Great Recession, but we have now created an environment where market participants may need to assume that rates could be at the zero bound for much longer than any of us ever dreamed. The longer the Fed postpones normalization, the more difficult the return to normal markets is going to be.

As an aside, I still think the Japanese yen is going to get weaker against the dollar long-term. My personal trade was done with a 10-year option; but I have to tell you that if I was sitting in front of a dozen screens on a trading desk today, I would be covering all of my long dollar bets and dipping my toes into some short dollar trades. Thank the gods, I am not a trader, because that would be a hard trade for me to put on.

The Demographic Realities of the European Immigration Crisis

I called my good friend and geopolitical strategist George Friedman a few days ago and found him wandering the streets of Vienna, but we still managed to spend some time talking about the immigration crisis that is sweeping across Europe. I jotted down a few notes from him:

This is not simply about migrants. It is one more thing that shows Europe does not work and cannot make decisions.… What we are seeing before our eyes is the collapse of the European project. There is nothing meaningful when we say “EU.” It was an institution that functioned for a while, but countries are no longer paying any attention to Brussels.

Once again we are seeing divisions at the heart of Europe based upon economic and demographic realities. As I wrote in my book Endgame, the productivity and wage differentials between Germany and the European periphery have created massive trade imbalances. Normally these are solved through adjustments in the currencies of the countries involved, but the Eurozone locked in such imbalances, leaving as the only solution a deflationary collapse in wages. This has of course also drastically increased unemployment in the peripheral nations.

Those problems, coupled with the massive debt run-up in the peripheral countries, has opened up a yawning divide in Europe. Greece is only the first country to totter at the edge of the abyss. And yet Germany remains a profound believer in maintaining austerity until true reforms have been implemented. No debt relief without reforms is their mantra.

For Europe, the Grexit and refugee issues are two manifestations of an underlying and much more problematic challenge. The continent’s various unification measures are in danger of coming unraveled.

Avoiding Grexit was relatively easy. Yes, the fights were ugly, but it was a simple matter to sweep everything back under the rug. Sweeping a few million immigrants (you don’t think they’ll stop coming, do you?) under the rug is a much greater challenge.

How Europe handles the refugee crisis is potentially far more important than the Grexit issue. Some bad decisions could lead to serious problems in not too many years. This is a major development.

And the immigration crisis highlights another deep divide.

A New East-West Rift

German Chancellor Angela Merkel says the country will accept 800,000 refugees this year. Even considering Germany’s size, that is a very generous number that has earned Merkel praise from humanitarians everywhere. At the same time, European Commission president Jean-Claude Juncker wants to impose quotas for refugees and immigrants upon the entire European Union. He has come up with the idea of “shared responsibility” to push this new doctrine.

This is all well and good for nations like Germany that need immigrants, but much of Europe is really not in need of new workers, given their present severe unemployment problems. Not to mention that in those countries budgets are already strained and taking on the task of housing tens of thousands of immigrants and refugees is not cheap.

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Important Disclosures