Good Questions for Noda

Over at Shisaku, Michael Cucek asks some good questions about what happens next. This one especially is a puzzler:

Does a rush to the bond market, heartened by Noda’s message of a reduction of Japan’s deficts (reducing the debt is not a realistic prospect) send the stock market into a tailspin?

It’s a good question but there are massive contradictions to deal with here. While sending out a message that basically says “we’ll increase the tax base (eventually) to reduce the deficit”, Noda is signalling that he’s in favour of weakening the Yen. In any rational world the Yen should be going to hell, and yet somehow (hmm, what could it be?! An export economy, importing the majority of it’s raw materials priced in dollars, perhaps?) the Yen, along with the Swiss Franc, is stronger than ever. The FT reports today that the Yen is now 47% higher against than it was in 2008. Ouch.

It seems things are not entirely reality based. The US and Europe are in a desperate race to the bottom, and Japan really can’t compete in the financial armageddon stakes. My guess is that Noda will be forced to live with a strong yen, and a high debt level. Meanwhile something with force of the PIIGS into a default, bondholders will (with bad grace) eat their loses, and lash out, bring down all sorts of mayhem on all our heads. At the end of all this Japan will still owe it’s citizens a bunch of money, but not much else will change there.

The adage about the futility of betting against the Yen is likely to hold a little longer…

Seven Charts and a Curious Conclusion

I’m confused. “Well”, i hear you say, “there’s a surprise!”

Since Uncle Ben announced it latest round of debt monetization (QE2) the dollar has strengthened against the Yen. Not by much, but it has been consistently in one direction. Obviously this will change now that i’ve mentioned it…

This article has (you guessed it) seven charts of the dollars performance against various currencies. I’ve never been able to get much out of, so called, technical analysis. In fact, it’s usually translated in my head to ‘testicle analysis’ as it seems to be only so much bollocks…

That being said, the following chart of dollar / yen since 1976 indicates to me that there is basically one relentless trend:

If you were going to bet on one thing based on that chart it would probably be that the yen is going to continue to strengthen against the dollar. The last couple of decades of deflation in Japan have provided some respite for the yen, but with the comparison being between a contracting US (with a massively negative trade balance, and a money printing, actively dollar debasing, Fed) and a moderately deflating Japan, it’s obvious that we’d be testing new lows.

All of which makes the following conclusion to the article:

The key take-away: A grossly weaker dollar is not an economically or politically acceptable proposition for the world. And trouble for the world economy represents trouble for the U.S. economy.

So, despite all of the bold projections of a continued rout in the dollar, these seven charts suggest the exact opposite outcome could be around the corner.

Wha?

The missing piece, in what i’ve said above, appears to be the following chart:

which shows the relative values of currencies (against the dollar?) The Yuan is the obvious standout here – over the period of the chart it has risen only modestly, which everything else (of import in the world of currencies) has headed for the roof. This makes chinese export (relatively) more (price) competitive.

The argument is presumably that this collective need for a strong dollar (it is after all the world reserve currency, not just the currency of the US) will override the desire of the US to devalue the dollar, to boost exports. I’d have more sympathy for this argument if the US was an export powerhouse, but that hasn’t been the case since the 50s, and there are only so many wars you can ferment to increase arms sales… and when something like 80% of your manufacturing base is in the “defence sector” that’s a reasonable consideration!

Thus far the collective desire for a strong dollar has not amounted to much, unless one assumes that it has been a case of attempting to ‘talk the dollar up’, an no real action has been taken.

There we are: i’m confused. The dollar is obviously weak and i can see no reason why it should not continue to weaken. However, it’s strengthening, and  people are convinced that this is to be expected.

Don’t know what to think… except that markets can’t be rational if they are based in the complex (and irrational) behaviours of traders following there hunches and muses!

Another Yen / Dollar Theory

There is a quite a lot of talk about the dollar carry trade. In essence this means that dollars are being used to buy assets (other currencies) with higher yields. This is, in effect, selling the dollar. This selling causes the value of the dollar to fall relative to the currency being bought. (I’m not sure if that part is right. It doesn’t seem right that selling the dollar and buying another asset would cause the value of the dollar to fall against all other currencies, so i’m assuming…)

If the yields for holding dollar denominated assets rise (stock market indexes, or bond yields, increase) the non-dollar assets are sold to buy these now higher yielding assets. The value of the dollar rises relative to the currency being sold. (similar caveat to above)

As the dollar carry trade is currently considered to be huge (larger than the yen carry trade that proceeded it!) the effect on the value of the dollar is large. However, the stock markets in the US have been rising for some nine (plus) months, which must temper some of the possible decline in the dollar. There are also different classes of risk, meaning that some of the money flowing around might consider the equity markets too risky, and would flow into government bonds (with higher yields than US treasuries). In all likelihood, given the general trend of massive public sector borrowing, there are lots of high yielding bonds out there to buy. If holding these bonds becomes too risky, the money will flow out again, back to lower yielding, but presumably safer assets (US Treasuries, for example).

Assuming that there is some kernel of truth in the above, it makes sense that the Yen is remaining stubbornly strong against the dollar, even while everyone and their dog is predicting japanese sovereign default. Yields on japanese government debt are low (because the debt is held in Japan …that’s not really an answer, but let us just say that it is possible for the MOF to borrow cheaply, just “because”) and other yen denominated assets are not attractive (deflation; would you want to buy a shrinking pie?!) Therefore, very few of the dollars that were sold resulted in yen being bought. And conversely, as these carry trades unwind, very little yen is being sold…

Having written all that down, i’m not convinced… all it says to me is that the yen is sort of in a no-mans-land, languishing in the doldrums, while the action happens elsewhere. Perhaps it’s just that with a positive trade balance, companies are constantly having to buy yen to repatriate revenue.

Relationship Reset?

This (fictional) piece is the best from my (limited) weekend reading:

The following fictional conversation never occurred in June 2009 between Treasury Secretary Tim Geithner and a Chinese negotiator named Cheng for the sale of U.S. assets, at least not that we know of. 

 — USA Fire Sale, 2nd Meeting, June 2009: Political capital call, iTulip.

Some of the ‘human rights’ stuff cuts a little close to the bone. It’s almost as if the Americans (i presume to be) writing this with that they had an authoritarian / repressive system to live under… there is, after all, no accounting for puritanical tastes.

Entertaining and informative. Sightseeing on the road to a financial brave new world!

After thought. A lot of what i’m reading reinforces my views that the Chinese (or more broadly Asia) is well aware of what it is doing, and will manage the descent of the West into a far more “equal” set of relationships over a relatively long period of time. Just like the frenzy of doomsaying around peak oil last year, our systems are a lot more flexible that it first appears – stretching them to the point of collapse takes time. This is presumably because we are highly adaptive, on mass easily manipulated, and delusional. It isn’t very encouraging, but it does go some way towards explaining why what appears to be a completely untenable situation can be strung out for so long. The obvious exception to this would be Gaia, which doesn’t really care how it kills us off, just as long as it shakes this fever.

Doom or Gloom?!

Doubt that’s a choice we’ll have to make…

As feared, stocks decline and bond yields rise, aka. a bond dislocation. <gulp>

It has begun. Today equities fell significantly and the “safe haven” bid was not large enough to overcome a deluge of selling. Yields rose. Again. This is not likely to be an isolated incident. This while happen with greater frequency and increasingly disruptive consequences.

Hmm. I’m still not convinced. There was a huge auction of 7 year bonds today, which might have distorted the market. For sure there is a lot of stress in the bond markets due to amazing volume of government debt… but one swallow doesn’t make a summer, and all that.

Keep watching!

The Financial Ninja (also linked via the image above) seems to have his eye on the ball:

Giddy talk of “green shoots” has completely drowned out a more sober and rational assessment of the global situation. Random statistical noise in various minor economic indicators have over the past two months resulted in wild exclamations of “the worst is definitely over”.

It most certainly is not.

Yet another blog worth following as we mosey along in this wicker basket… can you smell sulphur? Perhaps it’s just me.

Update: I was wrong about the 7 year auction being yesterday, it was today. Yesterday was an auction of 2 and 5 years. The 7 year auction went off smoothly. More evidence for continued randomness rather than being at the point of systemic collapse. In theory the short end of the bond market should be more resilient than the long end… patience!

The Liquidity Pyramid

Go look at the picture the accompanies this piece, take note of the numbers:

Much speculation lately focuses not so much on what the stock market will do (the answer to that should be self-evident, especially once shorting stocks again becomes a practical reality), but what the impact of recent economic policies will be not just on inflation (regional or global), but also on that most sacrosanct piece of paper, the U.S. dollar.

Not much to add… seems like a reasonable analysis to me.

The trap is closing. Terrifying.

Unyielding

30 year bondBeen watching this graph recently – it has been behaving badly…

That’s the yield on the US Treasury 30 year Bond. You can see the yield being forced down 2%, to 2.5%, from November to the end of last year. Then it creeps back up to 3.5% over a period of several months, where it stabilises until mid-April. At which point it starts to slowly, relentlessly creep back up. All of which raises some interesting questions, like ‘what’s happening?!’, and ‘what does it all mean?!’.

That graph shows the interest rate (yield) that the government has to pay on it’s debt. The more worried that ‘the market’ is about the amount of money that the Treasury wants to sell, the higher this yield moves.

Which would be simple, but of course, things are never allowed to be simple. In order to have some control over the rate, the Federal Reserve (central bank) can print up some new money, and buy the debt from the Treasury.

Unfortunately this ruse doesn’t appear to be working, as you can see – the rate is moving up. How can this be? Surely the Federal Reserve is so powerful, in theory being able to print an unlimited amount of money, there should be no limit to the scope of it’s action.

The problem for the Fed is that the more money that they print, the more the damage the value of the currency. The more they damage the value of the currency, the higher they would be forced to push interest rates to protect it. Not doing so risks crashing the currency, which when we are talking about the dollar is a big deal. The world holds trillions of dollars in reserves, and would not take kindly to having it rapidly devalued.

Another option is to squeeze money out of the equity / stock markets. Money exiting the stock market, seeking safe haven in the bond markets would help stabilise the yield. Or at least that’s the theory… in  my mind it doesn’t really work, or to the extent that it does, is of marginal effect. Someone holding stock decides to sell it, and move the funds into treasuries. For this to happen a second party must be on the other side of the transaction, and buy the stock. Where is the extra money coming from?

It’s possible to argue that the extra money is cash that is sitting on the sidelines (Sideline Cash Myth) but this doesn’t seem to stand up to much examination.

It seems to me that this puts us back in our usual position: between a rock and hard place. On one hand the government needs to finance debt in order to attempt to stimulate the economy / compensate for all the money being destroyed as debts go bad, interest rates need to stay low to keep this debt affordable, and reduce financing costs. And on the other, the currency needs to be protected or the market will not be willing to buy the the additional debt due to low yield, and fears of default.

Therefore the governments of the west are attempting to keep the system ticking along in the hope that enough growth will return to allow the debts to be paid down. At this point in the cycle, the debts are so huge that, i believe, this is no longer possible, or is at best, extremely unlikely.

Keep an eye on that graph. Nothing radical is going to happen now, but i suggest this is how you’ll know who (the central banks or the markets) is “winning” the war.

As an aside, a lot of this talk is about the dollar, but that’s mostly because it the easiest set of data to work with. The same situation is playing out in the other western economies, and the various central banks are fighting the same battle. The interesting exception to this rule, as always it seems, is the Bank of Japan, which despite printing money like it’s going out of fashion, has kept the yield on the japanese long bond remarkably stable. Again, as usual, i don’t understand the mechanism by which this can be explained…

Defeat

Interesting things going on in the world of gloom, doom, and despair recently.

The FT is running an article where the US secretary of agriculture basically warns that there is food crunch ahead:

The US agriculture secretary has warned that unless countries take immediate steps to sharply boost agricultural productivity and food output and reduce hunger, the world risks fresh social instability.

“This is not just about food security, this is about national security, it is about environmental security,” he said on the sidelines of the first meeting of the Group of Eight ministers of agriculture.

Charming.

Lots of talk about the US Treasury ‘stress tests’ for the banks. The worst case scenario that they are using is predicated on the headline unemployment number hitting 10.4% by the end of next year (it’s currently 8.5%, and rising fast… it’ll probably hit 10% in a couple of month, maximum) and a decline in house prices of 29% from the start of this year, and over a similar period… they are currently down 22%, and, you guessed it, falling rapidly.

The other issue is that while stress tests might have seemed like a good idea at the time, now that the results have to be released, there are all sorts of dilemmas. If all the banks pass with flying colours were the tests rigged? If some of the banks fail, and are sent off to secure new capital over the next six months, what is going to happen to their shares? Will it provoke runs on the failing banks? Perhaps the results could be kept secret.. that always inspires confidence.

This is looking like a slightly different take on the old, ‘good bank / bad bank’ discussion. The outcome doesn’t stand much chance of being much different… the people will end up assuming the position (all of the risk) while the banks try to hide their losses. What a mess.

This piece by Cynicus Economicus is really worth reading (as are the comments). He makes a pretty good case for believing that the anglo-saxon system of capitalism has run it’s course, and that we are now going to live through a very different (and declining) part of the cycle. I’ve always been intrigued by the idea that societies develop in cycles, going from youthful exuberance, middle aged stability, to staid old age. There seem to be many examples of this… and i’m sure a lot has been written about it. I’m already reading too much.

The other aspect of that piece, that is far more worrying, is the idea that the Chinese have twigged to the idea that Fed printing money <cough> embarking on quantitative easing, is a de facto act of default on the debt. There is evidence out there that China is positioning itself to survive this figurative middle finger to the developing world. 

Graphs like that (from here) make it clear that the Chinese are very aware of the “dollar trap” and, if the reports of them moving to buying up natural resources, precious metals, etc. are to be believed, actively working to insulate themselves from the US attempting to inflate themselves out of debt.

It’s a disturbing prospect on many levels. Defaulting on debts denominated in the worlds reserve currency… seems like a road to terrible instability, economic warfare, and eventually, outright conflict. It’s always said that war is only way out of depression, and it’s easy to see why. Personally, i’m not convinced that it’s inevitable… an odd moment of optimism?

On another positive note, the sheer size of China’s dollar denominated reserves mean that they aren’t going to unduly rock the boat. They’ll be trying to beat an orderly retreat, reallocating into other currencies, and assets. This movement is going to take time. Meaning that those of us with exposure to the dollar might see a period of relative stability until the endgame (a new world reserve currency, that greatly reduces America’s influence) becomes obvious / inevitable.

It’s looks to me that China has their eyes on the prize and is very much playing to win… will be interesting to see if Japan choses to go ‘down with the ship’ or makes like a rat. There is a lot of historic baggage to be lugged around, but surely pragmatism will force Japan to reconsider it’s current position as the outsider in Asia.