What is really behind Japan's decision to prop up the yen? This is the most important question now, which, for some strange reason, no one seems to be asking!
Some question whether or not the Japanese intervention was successful, whether it's the amount needed to prevent the yen from appreciating again, what the euro will do in this context and the consequences for the different asset classes. But no one has proposed a serious analysis of the reasons that pushed Japan to defend the ceiling of Y82/USD.
And yet, that is precisely the most important question because, as I will try to show, this intervention is no more than a monetary sock-puppet which aims to attack, without necessarily being conscious of it, the deflationary plague that has infected the Land of the Rising Sun for over a decade now.
Enhanced trade competitiveness is not the culprit
As you can see in the graph below, Japan has in fact quickly returned to a comfortable trade surplus ever since the contraction triggered by the Great Financial Crisis and the subsequent collapse of international trade. The latest figures reveal a Y610 billion surplus in July (€5.5bn). Worse still, the July surplus with the U.S., the most affected by any change in the Y/$ parity, totals about $5bn, representing 70% of Japan's total trade surplus!
The country's lowest monthly trade surplus with the U.S. totalled $2bn, and the yen's appreciation to 83 from 100 did not stop the surplus from surging anew. As such, a drive to enhance trade figures and thus economic activity cannot explain Japan's decision to buy over $20bn to contain its currency (Y1.8 trillion).
And do not let yourself be distracted by noise coming from certain sectors (Japan Exporters Call for ‘Zero Tolerance’ on Yen Gain’), even if the noise makers do not appear to understand that they are a mere distraction
Japan's trade balance
Insensitive to the yen's exchange-rate! (Click to enlarge)
So, if seeking foreign trade advantage cannot explain the decision to intervene to prop up the yen (the MoF), we had better look elsewhere, beginning with a review of what has occurred in the past two years in Japan: An intensification of deflation. It is because deflation is intensifying. Since September 2008, consumer prices, excluding food and energy, have plunged 3.51%!
This steepest price decline ever recorded is equivalent in magnitude to the combination of the Asian crisis of 1997/98 and the stock-market plunge of 2000/02 (-3.58%), but much higher on an annual rate (-2%/year vs -0.70% at the time). Average Japanese wages declined another 0.3% in July, representing the 23rd consecutive monthly contraction!
Major department store sales fell by an annual 3.02% in August for the 30th monthly decline in a row. At Y434.7bn, sales volume was the lowest since this statistical series began publication in 1991 when August sales totalled Y627.9bn.
But the strongest evidence that a deflation trap has tightened its hold in Japan was provided Monday evening with the publication of the value of Japanese household financial assets at 30 June, which tallies with John Maynard Keynes's major theory, later developed by Hyman Minsky: The liquidity preference theory. For those who are unfamiliar with this concept, check out this link/report which I have kindly recommended to an enthusiast of the Wicksellian illusion: 'Liquidity Preference Theory Revisited—To Ditch or to Build on It?’ (The Levy Economics Institute).
Japanese households (like businesses) are continuously increasing their proportion of liquid investments at the expense of stock markets, where prices declined 15.4% in Q2 2010. As such, total household financial assets have contracted to their lowest level in a year.
It is perfectly logical in a context in which cash is increasingly expensive (deflation) that savers move to this type of investment, especially given the global uncertainty. And the longer the public becomes accustomed to this reality, with money market yields at rock bottom, the further it will move out the yield curve, flattening it and explaining 10-year JGBs (Japanese government bonds) at 1%. The link between deflation, decline in consumption as households constantly delay purchases due to falling prices, and unproductive savings has never been so well established!
Take a look at this study on the Japanese Post Office concluded at the end of 2009, which in the first page compares the financial breakdown by asset class of households in Japan, Germany, the U.K.., France and the United States. This study is very instructive in that it explains why savings investment flows in the U.S. for the past two years have been so positive for bond funds and so negative for equity funds.
If American households undergo a Japanese-style decade, this trend still will continue for some time to come, given the adjustments that will be needed. Since the implosion of the Bear Stearns hedge funds in the spring of 2007, there have been $280bn in subscription outflows from domestic U.S. equity funds and $585bn inflows to bond funds!
But let's return to Japan and the real reasons for this currency market intervention entailing dollar purchases and yen sales.
The BOJ is incompetent
First, let's acknowledge that the Bank of Japan is the most incompetent independent central of the developed world. The ECB at least has the excuse that it is confronted with a much less severe deflation threat than Japan while it remains obsessed by the old psychoses inherited from the days of the Buba and the Weimar Republic.
The BOJ, boasting all the benefits of a sovereign central bank on its own currency with the most indebted government in its own currency, may be unable to end the economy's deflationist spiral, due to stupid limitations set by itself on this effort. As for the amount of Japanese government bonds that it is ready to buy, their quantitative easing, supposedly the last card to play when key interest rates are 0%, set an investment ceiling of bank notes in circulation. This is the so-called Banknote Rule, decreed by the Monetary Policy Committee, at the initiation of the QEP in March 2001.
The adoption of this rule, which harks back to metallic Monetarism and whose arbitrariness is equalled only by its lack of macroeconomic justification, has prevented it from carrying out a real quantitative easing. That is too bad because a real QE would not only have brought down long-term interest rates faster and steeper but would have injected fresh liquidity to domestic savings in dire need of it and would have even de-anchored inflationary expectations (deflation in this case) and thus defeat this terrible Gorgon.
For the more ambitious readers, check out this link to the BOH web site where you can read the limits it place on its QEP: Japan’s Open Market Operations under the Quantitative Easing Policy, April 2005. What can explain this timid, not to mention incompetent move, given the perpetual appreciation of its currency in the context of declining prices?
If we also consider that the BOJ had set as a rule to sterilize its forex market interventions, which changes nothing in terms of short-term rates already at 0%, but which can lower long-term rates. That makes for a lot of bad faith.
From the point that the BOJ buys dollars (and sells yen), its increases the yen reserves of banks that generate no yield at the central bank, and this surplus reserves must automatically drag the overnight rate toward 0%. If the BOJ does not want to do this, it can carry out Open Market operations by withdrawing these surplus reserves and selling short-term treasury instruments. If rates are already at 0%, whether it does so or not changes nothing. In contrast, if the BOJ were to sterilise these interventions by selling longer-term JGBs instead of short-term instruments, it will stumble.
In the meantime, the BOJ interventions do not appear to be sterilised, with the central bank's deposit reserves increasing Y2 trillion this morning to Y17.1 trillion, which is the amount we estimated yesterday for the dollar purchases ($20bn).
And therein probably lies the real reason for the BOJ's intervention on forex markets: The MOF is twisting the BOJ's arm. Under cover of trying to influence the yen's exchange-rate, the Japanese finance ministry required the BOJ to increase 13% the amount of excess reserves in the monetary system in a single day. If markets ever decide to test the BOJ's determination, leading to a real dollar/yen battle, just imagine the increase in reserves in a few months.
Moreover, if we also consider that short-term rates are expected to remain at 0% for a long time to come ("extended period of time"), long-term JGB yields will be pushed downward, thus, helping with budget deficit financing.
However, I would like to make two crucial points:
First: Such an approach offers no guarantee of success in the fight against deflation. We have previously explained in detail why a huge increase in surplus bank reserves could not, in and of itself, create inflation in the absence of credit demand (deleveraging of households) and the existence of institutional deleveraging restrictions.
There is one simple, legal and efficient solution to this problem about which I am currently working on the theoretical fundamentals, so I must leave you in suspense. The debates on this topic are highly interesting and intense, and I hope that the outcome of this reflection will not leave you disappointed. But here is a small clue, with the following question. Your answers are more than welcome and will help me gauge the degree of the financial community's readiness: A monetarily and fiscally sovereign state, like Japan, is required to set taxes and borrow to match the expenditures in its budget: TRUE or FALSE?
Second point: Don't these interventions, which create surplus yen reserves of commercial banks with the BOJ, end up in lower excess dollar reserves of commercial banks with the Fed? (All opposing arguments are welcome!).
And does not this run counter to the policy of the Fed and thus risk the danger of precipitating a second round of QE which it has hesitated from launching until now?
In a still deflationary global context, we may see a competition of quantitative easings, depending on region and country:
the size of the output gap
The currency's strength (?), Japan, eurozone
Unsustainably high and long unemployment (US)
The continuation of the debt deflation process (CMBS, Housing US)
Fears for the weakness of the financial institutional systems (eurozone-PIIGS).
Even countries which seem to have pulled out of this morass, like Switzerland and Sweden, have changed their tune:
Riksbank: Delayed Rate Hikes Abroad Might Slow Tightening Cycle: ‘weaker development in Sweden and a lower repo-rate path in the longer term’.
Politique monétaire: la BNS maintient le cap : Our translation --> "The central bank is revising downward its inflation estimates. It now projects inflation of 0.7% in 2010, 0.3% in 2011 and 1.2% in 2012. In June, the issue institute's inflation projections were for 0.9% this year, 1% in 2011 and 2.2% in 2012.’
‘UN Says Europe, U.S. Face `Deflationary Spiral' : ‘Premature fiscal austerity in Europe and the U.S. is pushing the global economy closer to a “deflationary spiral” that will choke consumption and leave millions of people without work, the United Nations said.’
In conclusion, Japan's intervention on the dollar market will have one major consequence: it will increase the probability that the Fed will launch a QE2.
That's enough for today.
I realize that today's Thaler's Corner does not make for easy reading, but I really think the constant search for new information on these highly interesting topics, such a the reality of monetary operations in a world in which currencies are no longer convertible in gold (ah, that is another index altogether) is more than worth it.
It may appear strange that I have not changed my asset allocation biases, given my fair positive view on fixed interest rate instruments (without necessarily being negative on equities) and everything I have just written, but those thoughts are for the medium term. We once again directed by capital flows, like today's asset allocation trade rick-off.
Asset allocation biases and advised option strategies
Our Bund target is now 2.70% on 10-year GGR, i.e. 128 on the December Bund.
In view of the progress already made, we have taken some nice profits for some well positioned clients on October puts, rolled over to the November maturity, on lower strike prices with lower delta and lower premia. That will pick up speed if the market really moves toward 128.We have also bought over 50,000 calls, with strike prices between 134 and 136, which were no longer dear enough to remain sellers.
2800/2900 on the Eurostoxx 50.
The Eurostoxx call ladders are working perfectly, given the hike in the spot price and the passage of time.
We have even suggested and set up for certain clients outright call purchases on the Eurostoxx on September and October, hoping for a little velocity and benefiting from affordable implied volatility! As valid as ever!
Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Greece 2 Y and 10 Y bonds, Long Eurostoxx50 ETF