On April 4th, 2013 the Bank of Japan made the following announcement:
"BoJ voted to double the monetary base and JGB holdings and more than double the average remaining maturity of JGBs in two years. The Bank is to adopt monetary base control as part of its easing program. The Bank expects to boost the monetary base by Y60 to Y70 trillion a year and plans to raise JGB buying by Y50 trillion a year. It expects to extend the duration of JGB holdings to seven years from the current three years. It plans to end the asset buying fund. It is ending the internal rule on limiting JGB buying temporarily. It expects that Japan's monetary base to be at Y200 trillion and sees its long term JGB holdings at Y140 trillion both by at the end of 2013. It projects that its long term JGB holdings will be Y190 trillion at the end of 2014. The BoJ will try to hit its 2.0 percent CPI inflation target in about two years. "
The U.S. Federal Reserve official statements I have read say it would be a good thing if the monetary action results in price inflation in Japan because of higher domestic demand for goods and services. My initial reaction to Japan's open market buying program was that it was an in your face counter-punch by the Japanese to the massive Fed bond buying program in the U.S. intended to drive U.S. employment by weakening the USD.
The massive measures being taken by the Fed through its Quantitative Easing program can be seen graphically below. Upon initiation of the program in September of 2008, the actions were focused on counter-acting asset price deflation, not to create consumer price inflation. And since the beginning of the program, on both of these measures, the program has delivered monetarily its intended purpose.
The extension of the program into QE3 however, embarked on a different goal than the QE1, QE2 and initial unconventional asset purchases. The QE3 program is expressly focused on obtaining an employment goal as measured by the unemployment rate. The Fed has two ways it can push employment through monetary policy. One, it can ease reserves through member banks and force more lending across the U.S. economy. However, continued emphasis on banking stress tests and the measured lack of lending by larger banks tell me this is not really what Treasury in conjunction with the Fed intend to accomplish with the new Fed QE program. They are leaving this heavy lifting to the shadow banking market (See article: Prospect Capital and the Re-Emergence of Collateralized Loan Obligations). In fact, it looks to be quite the opposite. It appears the Fed is trying to make sure the big banks are prepared for some kind of financial Armageddon - what might that be?
The FED asset holdings in QE3 will expand from the current $3T to $4T by the end of this year. Such an action if not countered by foreign governments in some fashion would have the effect of weakening the USD, and therefore enhancing trade based U.S. employment.
The QE3 program, as large as it is, is again couched in Fed-speak as "not going to cause inflation". And again, this appears that it is very likely to be true on an aggregate consumer price index basis. In points past, when the US initiated large scale increases in U.S. Treasuries, it has been able to generate inflation. Such periods are shown in the chart above and include the 1940's when active purchases of U.S. debt which monetized U.S. debt first began, and then again in the 60's and 70's when active monetization of U.S. government debt lead to high inflation. But those were different times because they were not countered by large interventions by foreign buyers of the U.S. Treasury debt.
However, equity asset markets are predictably on track for a return of the financial instability that was prevalent in 2006-2008. Financial instability, potentially "Armageddon" is the biggest risk of the QE3 program.
And here is the reason why.
What Not to Expect - A Run on U.S. Treasuries
I can say with high confidence that the one risk that the U.S. does not have presently is a mass exodus of buyers in the market for U.S. Treasury debt. As the reserve currency for the world, the demand is very high, and the Treasury can easily begin a sale tomorrow of its held reserves - and probably not cause a severe upturn in interest rates. This is because of the extremely high foreign demand for USD denominated reserves in support of trade with the U.S. and around the world. This trend is clearly shown in the chart below which tracks the ownership of U.S. Treasury securities.
The interesting aspect of this chart is that contrary to the public disdain for the Fed QE programs, Fed policy on a relative basis to past ownership levels is not out of the ordinary on percentage terms - at least not when it comes to U.S. Treasury debt. If you measure it on the basis of the last time the Fed used an extended repressive interest rate policy - 1937 to 1952, it is only slightly elevated, and is still below the 1970's. It is the Fed buying of other assets which is well out of the ordinary, and probably because it is targeted at a depressed housing market at least to date has not yet produced large increases in money supply growth.
The real change visible on the graph above is the foreign ownership line. This is the counter to Fed inflationary monetization of U.S. debt - it is deflationary. It represents the indirect financing of U.S. consumption of foreign manufactured goods through a build-up of U.S. Government Debt relative to GDP, which is being financed by foreign governments. The "China effect", as I call it, really began in the early-1990s. The U.S. policy since that time has always been to look the other way as the Asian countries actively entered the U.S. bond market with currency received from trade and instead of using it to purchase goods and services either in the U.S., or some other country that would eventually trade with the U.S., they began storing (almost hoarding) the USD in U.S. government bonds. We have witnessed the long-term decline that has resulted from this government policy and the resulting debt load in the U.S. moving over 100% of GDP because of it. But the debt load in Japan, to finance the hoarding of U.S. currency and fuel its export economy is also massive at over 200% if the country's GDP.
What these countries will not do, unless forced (highly unlikely), is unwind this trade. In fact, the trade on U.S. Treasuries post the BOJ announcement on April 4th predicts that foreign demand for U.S. Treasuries is going to be even higher in the coming months and years. This will not result in inflation in Japan - but rather continued exporting of deflation to the U.S. - just as has happened for the last 20 years.
This is why I say the massive monetary announcement by the BOJ was a calculated counter punch in the currency war targeted to make it more difficult for the U.S. Federal Reserve to have any measurable impact on U.S. employment through a weakened USD. In WWII, it is the analog of Pearl Harbor, not the signing of surrender in Tokyo Bay in September 1945.
Market Reaction - Test of Deflation or Inflation Expectations
The true test of what I have laid out in this article is real traded market reaction.
The interesting aspect of the YEN trade is that it is a continuation of a weakening trend since September of 2012. It would appear likely the Japanese were already actively pursuing the more aggressive asset purchase policy since mid last year. The YEN has now weakened to levels it traded pre the US stock market crash of 2008, and likewise U.S. equity markets have staged a comeback to all-time highs. If the Japanese are not already well down the path of their asset purchase program, then capital outflows from Japan into other currency markets could be substantial, and should drive up asset prices in US dollar terms - but that is not what is currently happening in commodity markets. Gold has continued to trade off in dollar terms since the announcement. Likewise, oil has declined as well. These are deflationary market reactions - not inflationary.
The U.S. Treasury markets also signaled deflation and low growth as well post Japan's announcement. The immediate reaction by the credit market was a rise in prices and drop in yield across the entire term structure of interest rates as shown in the graph below:
And, the stock markets in Japan and the U.S. (DIA) (SPY) (EWJ) have continued upward, as Fed QE3 plus an enhanced view that JGB bond buying by the Japanese will cause an influx of capital seeking yield. This would be a move which at this stage I would be very cautious in chasing. There are plenty of indicators that show the current U.S. equity markets are tired, and an influx of capital chasing yield without economic growth underpinnings will drive financial instability. On many measures the current equity market valuations are approaching the unstable trading range experienced in the 2006-07 market. In particular I point to the rising leverage in the business lending market, consumer loan demand and the corresponding contrast of very low top line revenue growth and consumer incomes on which to amortize the loans.
Follow the Credit Market Signal in your Portfolio Moves
The stock market is usually the immature sibling of the bond market in judging market turning events. In my view, the bond market trade gives a very real idea of the true impact the market can expect from the BOJ action - and it was not inflation and economic growth - good for stocks, but deflation and lower U.S. growth that was expected.
Commodity markets are also signaling deflation. Gold is the market that has everyone puzzled. It seems to me to point to possible reserve sales by Japan to support monetary base expansion goals.
The oil markets have also weakened. However, the oil market has a counter-balancing demand element worldwide that will stem deflationary moves in other consumer goods. And oil producing nations will not sit idly by why developed countries pursue a currency race to the bottom.
In the years to come, inflation pressures in the currency war will be measured in the level of food and energy inflation in the developed economies. So any attempts to weaken the USD to encourage employment from export led manufacturing is futile, and simply moving the "deck chairs on the Titanic". Continued QE in the race to the bottom with Japan in my opinion will only lead to financial market instability - just as it did in 2006-07.
With the BOJ move, and the continued Fed asset buying program, the following changes are advised for investors as we progress through the 2nd quarter and the remainder of the Fed QE3 program this year:
- It is time to get vigilant in your corporate credit portfolio holdings by shifting back to quality (LQD) and away from junk. (JNK) (HYG)
- Treasuries are better than cash in a deflation scenario, so you can underweight cash, and move money out of risky assets and overweight quality - and in the coming 2-3 years be better off. Treasuries across the entire term structure are very unlikely to go down in price by any large measure anytime soon because the Fed is in repressive interest rate mode - meaning they intend to continue to use member bank balance sheets to fix the pricing of U.S. government debt - not to drive loan growth. (GOVT) (IEI) (IEF)
- Don't get caught over-extending on the risk curve at this time. I would scale back on aggregate equity indexes, especially as the signs of economic weakness continue to show. If you try to time the impending market move, you will very likely get caught in a trade which will take years to get your money back again.
- Stock selection is the only way to play equities at this time. Use the energy and commodity market pull-back to continue accumulating hard assets and food companies, as food and energy prices are the primary market that consumer price inflation will materialize in the coming years, and stocks in this case should appreciate in value.
I have never lost money by leaving profitable trades too soon. The Fed may extend this party 3, 6 or 12 months, but eventually the market will be driven back to the level where we began this year and then below. A true sustainable upturn will only happen when we can exit repressive rate policies, when we see Federal Reserve member banks being true lenders in the private economy, not just an intermediary where they are paid to churn the U.S. government debt; in other words, the financial markets will become a buying opportunity once the U.S. has a credible path to growth out of its large government debt burden and these massive government interventions go away.