Turkey pressing so hard for a rift between the US and Saudi Arabia?

Outlook:

We have a lot of distractions and no explanation of what is going on in financial markets and political developments. Why did stock markets so suddenly and seemingly without a trigger turn around again? It’s not as though earnings were bad or some other Event intervened. Why is Turkey pressing so hard for a rift between the US and Saudi Arabia? Why are emerging market stock markets taking so much heat? It’s not as though everyone didn’t know about the risk of repaying newly higher-cost dollar-denominated debt. We had the Fed’s dot plots long ago. 

It usually takes a Shock of some sort to set off a reversal. What is the Shock (or series of shocks) today? It seems rather lame to blame the Fed. We had the ending of QE years ago (2015) and rising dot plots ever since. Granted, the Fed doesn’t know where the neutral rate lies and has said it will be okay to exceed it, both statements equally frightening. 

We might blame the political environment. In the US, Trump eggs on a mob with “lock her up” while charging the Dems with mob rule, his usual projection of his own faults. He is now campaigning for Lyin’ Ted and calling him Texas Ted. Here’s a symbol of toxicity: somebody tried to bomb Soros’ house.

We can try to blame Italy as the source of a Grexit-like crisis again, when everyone is still exhausted from Grexit itself. As in the Grexit case, Italy has perfectly sensible reasons for its stance. We find utterly convincing EconMin Tria’s assertion that Italy has not recovered from the 2008-09 crisis and the new budget is an effort to jump-start the economy. But equally credible are the EC’s so-far unspoken complaints that failure to recuperate is Italy’s structural faults, too, and not just EC-imposed budget constraints. Those faults include the need for labor market reform, corruption, and the traditional reluctance of citizens to pay their taxes. During Grexit we had some tables showing tax compliance across several countries. Even the IMF’s Lagarde was exasperated on this one point.

At some point, Italy might get away with a non-compliant budget if it convinces the EC that it has plans for those shortcomings, but unfortunately, that’s not how negotiations between the EC and individual countries tend to work. The EC speaks and everyone else needs to listen. This asymmetry is a key reason why euro-skeptics call for the eventual demise of the eurozone as an institution. There’s another solution, too—Italy could show to the EC that it has some buyer of last resort that is not the ECB for its planned debt. Who could that be? Well, there’s the IMF, and there’s Trump. The IMF comes in when there is a crisis, and so far is keeping its powder dry on Italy.

But Trump is another matter. Last August, Italian newspaper Corriere della Sera reported that Trump told Italian PM Conte the US would be willing to buy Italian government bonds, according to Bloomberg. This was deemed ridiculous at the time because Trump has no portfolio management capability. His motivation seems to be two-fold—to support another anti-immigration regime, and to throw rocks at the Establishment. Some say Trump is fulfilling Putin’s agenda by helping try to break up the EU and/or eurozone.

Is it really true that US cannot buy Italian bonds? No. Just as the Treasury holds gold or SDR’s, it holds foreign currencies. Technically the Fed manages US official reserves, but at the instruction of the Treasury. And the Treasury is under the control of the Executive. It “belongs” to Trump, who is not shy about violating norms and principles. Trump was probably just bragging about an ability to help Italy with no true intention to take action. But the idea is not entirely silly and certainly the kind of thing Trump does enjoy.

We doubt such a thing will come to pass, but it highlights the core shortcoming of the eurozone—an imbalance between institutions. A monetary union without a fiscal component is inherently unstable, as Larry Summers said even before the eurozone was created and Nobel-winner Stiglitz wrote in his tome about the euro.

Recently the website zerohedge re-published a Barron’s interview with retired Swiss investment manager Felix Zulauf, a former member of its Roundtable. Zulauf reprised the no-fiscal theme as a key reason why “established parties are in decisive decline, and anti-establishment organizations are rising. The risk of a hard Brexit is high. Italy doesn’t listen to Brussels any longer. It kept the budget deficit around 1% of gross domestic product in recent years, as instructed, which meant the country, with a dysfunctional banking system, had no growth and high youth unemployment. The March election brought anti-establishment parties to power that proposed a budget with a 2.4% deficit target. Eventually it will be closer to 4%. The Italian banking system holds €350 billion of government bonds. If 10-year government-bond yields hit 4%, banks’ equity capital will just about equal their nonperforming loans.

“By the middle of next year, you’ll see more fiscal stimulation in Germany, Italy, France, and possibly Spain. Governments will not care about the EU’s directives. The EU will have to change, giving more sovereignty to individual nations. If Brussels remains dogmatic, the EU eventually will break apart.

“The European Central Bank will quit quantitative easing by the end of this year. The economy has been doing well, the inflation rate has risen, and yet the ECB has continued with aggressive monetary easing, primarily financing the weak governments. This is nonsense. They are the worst-run central bank in the world. I expect the euro to weaken further, possibly to $1.06 from a current $1.15.”

Zulauf is not pulling any punches here. He’s also not giving credit to Mr. Draghi for holding things together by sheer force of will and intelligence and charm. But he has a strong point that the EU and EMU are at the doors of the existential crisis, again. We may have found the trigger for global discontent and disruption. It’s not Trump, after all. It’s not China, either, which may be huge and have huge troubles but is still an emerging market, after all. We got along without China before we had China and can get along without it now. No, the trigger is big, serious doubts about the design of the European Union. And nobody is forgetting where the last two world wars began.

The dollar may not deserve it, given the enormous new debt Trump is racking up, but it’s hard to see how the dollar is not the beneficiary of doubt, uncertainty and turmoil. Now let’s see whether the Swiss franc recovers its safe haven status, too.

 

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