For the past 7 months the world's financial markets have been held captive by "Abenomics," which has simply been rapid Yen (FXY) debasement mixed with bond buying, or quantitative easing, by the Bank of Japan. Introduced at nearly the same time as the Federal Reserve's current QE III+ policy, the two policies together are roughly the same size at more than $1 trillion each. And now that Abenomics has reached its limit of currency debasement, the Fed has begun talk of tapering back on its QE program.
The big question, however, is can they do so?
For the past seven months the Japanese bond market has seen unprecedented volatility, resulting in trading being halted numerous times. The Nikkei 225 (NKY) first soared and then put in a 50% Fibonacci retracement of its 7,000 point gain in less than three weeks.
In those same three weeks, the Yen has retreated from a spike high of ¥103.73 to where it sits as I write this, below ¥96. There is obvious support coming in from the BoJ as well as Japanese investors rotating back out of the Nikkei and into JGBs since the inflation Abenomics was supposed to engender did not materialize, except for food and fuel prices.
So, it's obvious that the Japanese are done pushing the yen down and now the bond buying portion of the program can take place to hold the yen in this region between ¥95 and ¥100. But, on the Fed's side of the Pacific Ocean, the Yen's rise has cut short the rally in the Dollar Index (UUP) and has exacerbated the rally in the dollar versus emerging markets. The Indian rupee, Singapore dollar (FXSG), Malaysian ringitt and That baht have all been hit in recent weeks.
So, if that's the case why are US Treasury prices falling?
The answer lies in this week's 3-year auction, which was miserable. The Primary Dealers took down more than 58% of the 3 year auction at a yield of 0.577%. The 10 year was better as the Primary Dealers only had to buy 38% of it, but did so at just over 2.2%, no doubt as some bargain hunters came in to dip a contrarian toe in the water, as it were. A close this month over 2.214% would be the highest for the 10-year note (IEF) since February of last year. Simply put, there isn't much demand for more Treasury paper at these yields.
The bond vigilantes are calling the Fed's bluff about the scaling back of QE and are demanding higher yields while taking profits in the face of all of this volatility. Since QE began the Fed has done nothing but talk about when it will end even though the program is open-ended. Orwell would be proud.
Real yields have been rising rapidly and the breakeven inflation rate has plummeted to 2.07%. The 10 year TIPS yield (TIP) turned positive for the first time in 19 months on June 7th, climbing more than 0.5% in the past month.
With this rate of change in the TIPS market the Fed will not continue to allow investors to believe that deflation pressures are winning the day. It is simply not going to happen under Bernanke, unless there is a mutiny by the hawks. Regardless of what you may or may not think about the efficacy of central banking it seems far-fetched that the Fed will sit idly by and allow the long end of the yield curve to rise much higher before attempting to arrest it.
So, where are we now? If we look at the situation in the market today we see that the net effect of these two radical policies have reset bond yields in Japan and the U.S. back to pre-QE levels in the 10 to 30 year maturity range, held the euro (FXE) near €1.30 +/- 0.03, pricked the price of gold (GLD) and forced the yuan (CYB) much higher while achieving a radical debasement of the Yen. All in all a good deal for the Fed.
What this means to me is the slow down in Fed credit created in May will likely not last much longer lest rates begin to rise dangerously high. The U.S. economy is weak enough that it cannot withstand a move by the 30 year bond back to a yield of 4% or 4.5%. Mortgage applications already began dropping in May when yields first started to rise. Now, auto incentives have reached 8% of MSRP, the highest level in 2 years and are not moving sales, according to Businessweek.
The above chart is what the QE taper looks like. Note the slow rate of growth in credit in May and the turnaround in yields. Couple this with the end of the yen debasement and a ramping up of "taper-talk" and we have an explosion in bond yields.
I expect all talk of ending QE will itself end very soon now. I am watching the long-dated Treasury market closely, looking for another technically significant weekly close, which would be above 3.5% on the 30 year bond and 2.39% on the 10 year note. If those events do not occur and we see a return of $100 billion-plus per month Fed credit expansion then we know that QE is continuing and the markets are comfortable with current yields and prices.
If, however, yields and Fed credit rise in concert then there is a real problem and I would expect at that point that gold will respond strongly to the upside as the last safe haven trade.