Category Archives: Economy and Meltdown

Will Japan's "Attempted" Reflation Succeed And Will It Spill Over Into Full-Fledged Currency War?

Yesterday we presented a simplistic analysis of why for Japan “This Time Won’t Be Different“, a preliminary observation so far validated by the just announced Japanese December current account deficit which was not only nearly double the expected 144.2 billion yen, printing at some 264.1 billion yen, but was only the first back-to-back monthly current account deficit since 1985.

In short – at least in the first month of Abe’s great reflation attempt, not only did trade post another whopper of a deficit, but so did the broader current account implying that much more Yen weakness will be needed to generate the structural reforms sought by the new Prime Minister.

But perhaps we are wrong and this time Abe will succeed where he, and so many others, have failed before. And, as is now widely understood, perhaps Japan will succeed in finally launching the necessary and sufficient currency war that would be part and parcel of Japans great reflation, as even various G-8 members have recently acknowledged.

The question is will it, and when?

One attempt at an answer comes from the fine folks at Bienville Capital who have compiled the definitive pros and cons presentation on what Japan must do, and how it will play out, at least if all goes according to plan.

What not even this presentation addresses is what happens if Japan is, in the end, successful in reflating, in the process beggaring all its neighbors, radically shifting the economic lay of the globe, and launching full blown currency war – far worse than anything seen to date, including the dark days of the 1930s.

Below are the highlights:

  • Monetary policy in Japan is undergoing a monumental change. For the first time in Japan’s post-bubble era beginning in 1990, it appears policymakers intend to drive real interest rates into negative territory. As a result, we believe the yen could continue to weaken and that Japanese equities could be in the early stages of a powerful rally
  • On October 30, 2012 the Bank of Japan and Ministry of Finance issued a joint statement entitled “Measures Aimed at Overcoming Deflation,” setting the stage for “powerful easing,” including what seems to be an explicit attempt to weaken the yen. On December 16th, 2012, Shinzo Abe was elected Prime Minister with a mandate to end deflation (i.e. to reflate the Japanese economy)
  • Although Japan has struggled with a deflating economy for nearly two decades, the timing of these actions is not random. For a variety of idiosyncratic, macro and geopolitical reasons, the Japanese economy is faltering. Partly as a result of a strong yen, industrial production and business surveys have deteriorated, and the revenues of several national export champions have collapsed
  • Due to negligible growth and deflation, the level of nominal GDP in Japan remains well below previous highs (Slide 4), a dangerous circumstance for an economy carrying the world’s largest sovereign debt burden. As history has proven, debt and deflation cannot coexist
  • In return for failing to reflate the Japanese economy, the Bank of Japan is on the verge of losing its independence. At the behest of Abe, it seems likely the BOJ will confirm a new 2.0% inflation target on January 22nd. In April 2013, the BOJ’s ‘hawkish’ Governor, Masaaki Shirakawa, is set to retire, likely to be replaced with a far more ‘dovish’ candidate (Slide 5)
  • In implementing monetary policy, the Bank of Japan is authorized to buy domestic and foreign assets, including equities and REITs (Slide 6). Achieving the 2% inflation target will prove difficult as domestic deflationary pressures remain. Wages, specifically, are contracting (Slide 7). Hence policy will need to be highly aggressive
  • In recent years, although the BOJ has expanded its balance sheet (Slide 8), it has risen far less than other central banks since the financial crisis began (Slide 9)
  • Regardless of whether the BOJ proves successful in achieving their inflation target, the expectation of aggressive policy can have a meaningful impact on the yen and Japanese equities, which remain at low levels compared to previous highs (Slide 10 & 11). Recently, equities have rallied and the yen has begun to weaken (Slide 12). But on a “real, trade-weighted basis,” the yen could fall another 20% before reaching the levels of 2007
  • To be clear, the intention of the additional policy measures in Japan is to enlist the “portfolio balance channel”—that is, to drive “real” interest rates negative, forcing Japanese savers out of cash and bonds and into riskier assets (i.e. equities). The Federal Reserve has attempted this process twice recently: in 2003 and 2009 (Slide 13), both of which resulted in higher asset prices. By contrast, real interest rates in Japan have remained positive, benefitting bondholders (Slide 14). High real rates also encourages saving over consumption
  • The 2003-2005 analog in Japan is interesting: monetary policy was aggressive, the BOJ’s balance sheet expanded by 25%, the yen weakened by 15% and Japanese equities rallied 125%. Of course this occurred during a period of global easing and reflation. In order to achieve today’s stated goals, the BOJ will need to be far more aggressive. For instance, in order to peg and maintain the Swiss Franc to the Euro at 1.20, the Swiss National Bank has expanded its balance sheet by 100% since August 2011
  • We believe the primary risk to this theme is lack of policy follow-through—that is, policymakers fail to act to the degree they are currently suggesting, as has occurred in the past. We currently believe this risk is minimal given the determined and coordinated communications from policymakers, as well as key upcoming events (e.g. Upper House elections, etc.). However, lack of policy follow-through would invalidate the theme
  • However, on a valuation basis, Japanese equities are relatively cheap (1.2x Price/Book versus 1.5x for other global indices) and yield 2.7%, more than 3x the yield from Japanese government bonds
  • International mutual funds are also currently underweight Japanese equities. Goldman Sachs believes international mutual funds’ allocation to Japan is 4% below benchmark (MSCI EAFE). If portfolio managers feel pressure to “get to benchmark, ” some $60 billion could flow into Japanese equities (in addition to the estimated $20 billion of recent inflows
  • Japan’s debt-to-GDP ratio is above 200%. Therefore, higher interest rates in Japan could be highly destabilizing. Today policymakers are undergoing a delicate balancing act: attempting to increase inflation and inflation expectations so that investors reallocate savings to riskier assets without causing nominal bond yields to rise. We are unsure of whether they can achieve this and continue to expect significant stress in the JGB market at some point. However, at the moment our focus has been to attempt to profit from a weakening yen and rising Japanese equities
  • To be sure, these events have significant implications for the global economy. To weaken the yen, the BOJ needs to buy foreign assets, and given the size of the purchases required, the likely candidates would be US Dollar and Euro-denominated assets. Neither the US, nor Europe prefer to see a meaningful appreciation of their currencies
  • A materially weaker yen also complicates the necessary global rebalancing process: the US and parts of Europe—i.e. current account deficit countries—need to move towards trade balance to achieve sustainable growth (i.e. a weaker USD and euro relative to some peers). By contrast, the surplus countries, notably China, Japan and Germany—the world’s 2nd, 3rd, and 4th largest economies—need to engineer more domestic demand, relying less on exports, or external demand, for growth. A policy-induced shift back towards export-led growth by the surplus countries would only rekindle the global imbalances that erupted in 2008
  • Having virtually exhausted its ability to grow through investment, China is unlikely to sit idle as Japan weakens the yen, stealing external demand in the process
  • Recently, the yen has weakened by nearly 20% versus the Korean won, one of Japan’s primary competitors, threatening Korean exports, which represent 50% of its economy
  • In sum, aggressive actions by the BOJ could escalate into a full-fledged currency war. Investors should be monitoring these events closely

Full presentation:

Lessons From The 1930s Currency Wars

With Abe picking his new dovish playmate, and Draghi doing his best to jawbone the EUR down without actually saying anything, it is becoming very clear that no matter what level of bullshit histrionics is used by the politicians and bankers in public, the currency wars have begun to gather pace. Japan’s more open aggressive policy intervention is the game-changer (and increasingly fascinating how they will talk around it at the upcoming G-20), as if a weaker JPY is an important pillar of the strategy to make this export-oriented economy more competitive again, it brings into the picture something that was missing from earlier interactions among central banks of the advanced economies – competitive depreciation. The last time the world saw a fully fledged currency war was in the early 1930s. Morgan Stanley’s Joachim Fels looks at what it was like and what lessons can be drawn for the sequence of events – there are definite winners and losers and a clear first-mover advantage.


Via Morgan Stanley, Back to the 1930s? What Would a Currency War Look Like?

What did the currency war of the 1930s look like?

The backdrop for the currency war of the 1930s was the Gold Standard and the Great Depression (many economists blame the former for the latter). By fixing the value of the currency to the price of gold, the Gold Standard prevented a country from printing too much money. If it did, people would simply exchange it for gold (or for other currencies pegged to gold). Yet, this rigid ‘rule’ also denied policy-makers any flexibility to deal with shocks to their economies. This was the reason why the UK abandoned this regime, setting off a volatile chain of events:

  • On September 19, 1931, sterling was taken off the Gold Standard. It was devalued against gold and hence against the ‘gold bloc’ currencies (currencies that remained pegged to gold). The run-up to this event and its fallout was felt throughout the world.
  • Prior to the devaluation, in June and July 1931, one prominent bank in both Austria and Germany failed, which led to capital controls being imposed in both places. Capital controls protected these economies in the near term, but exacerbated fears about the future of sterling and the Gold Standard itself.
  • Following the devaluation of sterling, Norway and Sweden went off the Gold Standard on September 29. A day later, Denmark followed.
  • The US economies, like other countries of the gold bloc, lost competitiveness and exports turned down. Eventually, in January 1934, the US Congress passed the ‘Gold Reserve Act’ to nationalize gold held by banks and monetized it by giving banks gold certificates that they could use as reserves at the Fed. More importantly, it also forced a devaluation of the US dollar against gold.
  • Like the US economy, the remaining gold bloc countries (France, Germany and some smaller economies) also suffered a loss of competitiveness and poor export and industrial production growth. By 1936, they gave up and abandoned the Gold Standard as well.

What lessons can we draw from the events of the 1930s?

 We draw three pertinent lessons from that episode:

Lesson 1: As in every crisis, events were and will always be highly non-linear, with domestic conditions the most likely cause: It was painfully high unemployment that was the main driver of the devaluation of sterling.2 Although unemployment had been painfully high for a while, it was only a few months prior to the devaluation that market fear really ratcheted up.


Lesson 2: Markets punish policy uncertainty: Needless to say, there were dramatic movements in the exchange rate of the countries that devalued. However, with the devaluation out of the way, market and economic pressure as well as policy uncertainty shifted to the ‘gold bloc’ economies. For investors, it became a matter of when, rather than whether, the gold bloc economies would be forced to respond.


Lesson 3: Early movers benefited at the expense of the gold bloc, a ‘beggar-thy-neighbor’ outcome: From an economic standpoint, the sharp improvement in competitiveness of the early movers stood them in good stead against the gold bloc economies who stuck to the regime. Exhibit 1 shows that the UK and the Scandinavian economies saw a significant improvement in industrial production by 1935, whereas the ‘gold bloc’ economies (France and Germany – even though the latter employed capital controls) suffered. By the time the gold bloc economies capitulated, they had lost significant ground on this front to the early movers.



Could it happen again? Like any historical precedent, there are differences and similarities that must be accounted for.

What’s different this time? Unlike the Gold Standard era, most major currencies are now part of a flexible exchange rate regime, which should make such large currency moves less likely. Further, extreme tail risks that might well have precipitated such dramatic policy responses only a few years ago have also receded.

What’s similar? Domestic origins and ‘beggar-thy-neighbor’ effects: Even though policy-makers battled using exchange rates, the events of the 1930s had their origins in domestic issues. As mentioned above, it was painfully high unemployment in England that led sterling off the Gold Standard. The competitive devaluations that followed were also reactions by policy-makers to protect their domestic economies.

Similarly, it is the domestic agenda that could drive competitive depreciation today. In this vein, the desire of Japan’s policy-makers to revive investment in their export-oriented economy likely means that the yen will likely play an important role. However, since global demand is likely to remain sluggish, a revival of Japan’s export sector on the back of yen weakness is likely to eat into the market share of other exporters – something that could well invite measures to curb significant weakening of the yen. These negative spillovers are identical in nature to the ‘beggar-thy-neighbour’ policies of the 1930s.

If it did happen, what could an improbable but not implausible sequence of events look like?

In what follows, we create a plausible sequence using events that have both a reasonable probability of occurring and are already on investors’ radar screens:

  • The starting point: Japan’s policy-makers initially follow a concerted plan of reflating the Japanese economy, with a weak yen as an important pillar of strengthening the export sector.
  • Further easing from the major central banks… The ECB and/or the Fed ease further due to a deterioration in financial conditions. In the case of the euro area, euro strength or an idiosyncratic increase in risks might be responsible for a tightening in financial conditions. In the US, the obvious candidate is the risk surrounding the fiscal cliff and the debt ceiling confronting the US Congress.
  • …and/or capital controls from EM economies: Uncomfortable with the combination of further capital inflows and yen weakness, some AXJ and LatAm economies impose capital controls.
  • Japanese policy-makers react to yen strength: In order to ensure export competitiveness, Japanese policy-makers take further measures to weaken the yen.

There isn’t much in the ‘timeline’ above that is news, yet the combination serves well to illustrate how a currency war could plausibly play out.

Where are we now?

The key variable in the sequence of events above is the reaction of Japan’s policy-makers. If a weaker yen is indeed an integral part of their plans and if they have a strong intent to make sure it remains so, the risk of a currency war is higher now than it has been in the past. Investors have moved beyond questioning whether EM economies will have a response and are now wondering at what point such a response is likely. At the same time, near-term risks in the US and euro area economies remain in play, as does the prospect of prolonged or even enhanced monetary stimulus.

In the EM world, Japan’s export competitors in AXJ could respond with some combination of verbal intervention, FX intervention, capital controls and, with a much lower likelihood, policy rate cuts. In the particularly interesting cases of Korea and Taiwan, our economist Sharon Lam believes that verbal intervention (already under way to some extent), intervention in the foreign exchange markets and capital controls represent the most likely policy reactions. Rate cuts at a time when both economies are already expanding may serve to accelerate domestic growth and perversely cause even more capital inflows and currency appreciation rather than depreciation. For moderate moves in the yen’s value, the effects on China are likely to be limited since it does not compete head-to-head with Japan’s high-end electronics and car exports. However, in a currency war situation, the slow-moving USDCNY exchange rate may make restoring competitiveness tricky.

However, even as we discuss AXJ, let us not forget that other parts of the EM world are also concerned about currency appreciation. For all the talk about potential policy action in AXJ, we have already seen some of it come out of Latin America. In contrast to AXJ, Latin America is slowing, which puts rate cuts firmly on the agenda. Indeed, Colombia’s recent rate cut was likely influenced by the peso’s strength. Luis Arcentales, our Mexico economist, believes that concerns about the currency war have also probably been an influencing factor in Banxico’s u-turn towards a dovish stance from a hawkish one just a few weeks ago. In an innovative twist to the usual FX intervention, Peru has announced that it will buy back its international bonds and issue ones denominated in its domestic currency instead. Even Chile, one of the most advanced and stable EM economies, is discussing structural reforms to address the strength of its currency.

In summary, while a currency war is not our base case, the new-found commitment of Japan’s policy-makers does raise the risk of retaliatory action to keep the yen weak, and brings us a step closer to a currency war. The experience of the 1930s suggests to us that such large currency crises are likely triggered by domestic issues, and that they do create distinct winners and losers. EM policy-makers are already gearing up to make sure they remain on the winning side, but the balance of power for now rests with Japan.

Guest Post: When Lindsay Graham And Barrack Obama Agree… Run The Other Way Fast

Submitted by Michael Krieger of Liberty Blitzkrieg blog,

The easiest way for a patriotic, civil liberties defending U.S. citizen to know whether to support or oppose an issue is when two of the most authoritative, narcissistic politicians from the two controlled political parties in America are in strong agreement. In this case, I am referring to Lindsay Graham and Barack Obama’s recent love fest on drone warfare.  From Politico:

Sen. Lindsey Graham (R-S.C.) will offer a resolution next week commending President Barack Obama’s use of drones and the killing of Anwar al-Awlaki.


“Every member of Congress needs to get on board,” Graham said. “It’s not fair to the president to let him, leave him out there alone quite frankly. He’s getting hit from libertarians and the left.

“Everyone needs to get on board…” in commending the death of someone from 30,000 feet?  What kind of Nazi talk is this?  So this is what America has become.  Politicians with 10% approval ratings patting themselves on the back for killing other human beings without ever getting their hands dirty.  USA! USA!

Full article here.

"An Economy Built On An Illusion"

From an op-ed by George Melloan, posted in the WSJ, and can be read in full here

The Fed’s Asset-Inflation Machine

Asset inflation often produces something called “wealth illusion,” the belief that pricier asset holdings necessarily make one permanently richer. Illusions are dangerous. Eventually, painful reality intervenes.

* * *

President Obama and Mr. Bernanke worsened the effects of the 2008 crash by adopting the same Keynesian antirecession measures—fiscal and monetary “stimulus”—that had failed before, most dramatically in the 1970s. Stanford economist and former Treasury official John Taylor recently argued persuasively on these pages that “stimulus” measures had retarded rather than speeded recovery.

Mr. Bernanke will have great difficulty letting go of the near-zero interest rate policy without severe consequences for both the Fed and the economy. The Fed’s own economists recently warned that the Fed itself could lose as much as $100 billion on its vast portfolio when bond prices finally fall from their artificially elevated levels. Meanwhile, higher interest rates will cause the cost of financing government debt to skyrocket.

The Fed policy of quantitative easing is designed to rebuild the asset inflation edifice that collapsed in 2008. German banker and economist Kurt Richebächer provided some of the earliest warnings of the dangers. In his April 2005 newsletter, he wrote that “there is always one and the same cause of [asset inflation], and that is credit creation in excess of current saving leading to demand growth in excess of output.”

Richebächer added that “a credit expansion in the United States of close to $10 trillion—in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000—definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation.” Richebächer died a year before the debacle of 2008. The crash that surprised so many bright people wouldn’t have surprised him at all.

The rising Dow is of course good news for savers, who have been forced into equities to try to find a decent return on investment. Thanks to Fed policy, “safe” 10-year Treasury bonds yield a near-zero or negative return, depending on whether you measure price inflation at the official rate or at higher private estimates.

Winners on stocks or land holdings should happily accept their gains as the best to be expected in a very unsettled financial environment. But they should also remember the 2000s, when so many people thought their newfound riches were real and cashed them in for yet more debt, such as home-equity loans.

They later had a rude awakening. The “wealth illusion” of asset inflation is seductive, which is why central banks in charge of a fiat currency and subject to no external disciplines so often drift in that direction. Politicians smile in satisfaction and powerful Washington lobbies cry for more.

But an economy built on an illusion is hardly a sound structure. We may be doomed to learn that lesson once again before long.

* * *

And visually:

DOJ Scrambles To Appear Impartial, Says "Don't Think Moody's Is Off The Hook"

While Moody’s slipped over 20% when the DoJ announced its cajillion dollar lawsuit against S&P for knowing the crisis was coming but not telling anyone, it later bounced back over 10% as investors believed the non-US-downgrading rating agency (that happened to be owned by Buffett) was too-big-to-jail. After-hours today, Reuters is reporting that the Justice Department and multiple states are discussing also suing Moody’s Corp for defrauding investors, according to people familiar with the matter, but any such move will likely wait until a similar lawsuit against rival Standard and Poor’s is tested in the courts. The stock is trading down 3% after-hours as sources (not authorized to speak publicly) added “don’t think Moody’s is off the hook.” We can’t help but think about the pending sequester-delaying deficit spike as perhaps, to appear impartial, the DoJ will keep the threat of a lawsuit against Moody’s alive… during the entire period when the US may and should be downgraded.



U.S. Justice Dept, states weigh action against Moody’s

* Federal, state actions contemplated against Moody’s

* Connecticut case against Moody’s proceeding to trial

* Lawyers say stronger paper trail exists against S&P

By Aruna Viswanatha and Luciana Lopez

Feb 7 (Reuters) – The U.S. Justice Department and multiple states are discussing also suing Moody’s Corp for defrauding investors, according to people familiar with the matter, but any such move will likely wait until a similar lawsuit against rival Standard and Poor’s is tested in the courts.


Inquiries into Moody’s are in the early stages, largely because state and federal authorities have dedicated more resources to the S&P lawsuit, said the sources, who were not authorized to speak publicly about enforcement discussions.



Moody’s in the past has defended itself against similar allegations, including a 2011 congressional report that concluded the major ratings agencies manipulated ratings to drive business.



“Don’t think Moody’s is off the hook,” said one law enforcement official.


Another rival, Fimalac SA’s Fitch Ratings, is unlikely to face similar action, the sources said, since it is a much smaller player in the U.S. ratings industry. The firm also escaped the brunt of scrutiny from congressional investigators.



A similar coordinated federal-state action against Moody’s would follow lawsuits two states have already filed against the ratings firm. Connecticut, which led the states in this week’s actions, sued Moody’s and S&P in March 2010.


In January a state court in Hartford denied the last of the preliminary motions Moody’s had filed to have the case thrown out. That case and the one against S&P are proceeding to trial in the second half of 2014.


Those earlier cases and the more recent ones against S&P are based on a theory that the firms misled investors by stating that their ratings on mortgage products were objective and not influenced by conflicts of interest.


Instead, the lawsuits contend, the firms inflated ratings and understated risks as the housing bubble started to burst, driven by a desire to gain more business from the investment banks that issued mortgage securities.


Framing the cases in that manner steers clear of attacking individual ratings, which have largely been shielded under free speech protections. Instead, the focus is on proving false just one statement S&P made – that its ratings were objective.




“It may very well be that the government’s testing their waters and they don’t want to bite off more than they can chew,” said Philip Hilder of Hilder & Associates in Houston, a former federal prosecutor. “Nobody should take these cases lightly.”