Nikkei Soars, Japanese Bond Yields Collapse On BoJ Front-Running

If there is one thing the Fed taught the world’s investors it was to front-run them aggressively; and whether by unintended consequence or total and utter lack of belief that despite a ‘promise’ to do ‘whatever it takes’ to stoke 2% inflation the BoJ are utterly unable to allow rates to rise since the cost of interest skyrockets and blows out any last hope of recovery, interest rates are collapsing. Japan’s benchmark 10Y (that is ten years!!) yield just plunged from 55bps (pre-BoJ yesterday) to 34bps now. That is a yield, not a spread. Nothing to see here, move along. Of course, not to be outdone, Japanese stocks (Nikkei 225) are now up 6.75% from pre-BoJ (3% today) trading at 13,000 – its highest since September 2008 (Lehman). But there is one market that is showing its concerns at Japan’s inevitable blow up – Kyle Bass’ 1Y Jump risk has more than doubled in the last 4 months.




and TOPIX vs JGBs…


meanwhile, in 30Y JPY Swaps…


and the long-end of the JGB curve is clearly getting whacked with technicals (or just simple old front-running on the BoJ’s extension) as it is looking very ‘deflationary’ relative to FX and stocks…


as JGB 5s10s collapses back across its 20 year channel…


JGBs vs Trade Deficit…


and one of Kyle Bass’ preferred ways to play Japan – through 1Y jump risk (CDS) – has more than doubled in the last 4 months…


Charts: Bloomberg


Guest Post: The Fallacy Of The Fed Model

Submitted by Lance Roberts of Street Talk Live blog,

On April Fool’s Day Martin Hutchinson released an article entitle “This Little-Known Indicator Says Stocks Should Double.” stating:

With the markets breaking all-time highs last week, it begs the question of just how high they can go.  At 1,569 points the bears would say at this point the S&P 500 is completely overdone. With a sluggish economy and a growing federal deficit, you might be prone to believe them.


But there is a little-known indicator that became very fashionable between 1982-2007 that says something else entirely. Noted for its accuracy over that period, it actually suggests that stocks should double. 


It’s called the “Fed Model.”

Now, before you assume that I am attacking Mr. Hutchinson’s view point, I want to clarify that even he suggests that “…the Fed Model is only right by accident.  However, lots of people follow it…”  This is the primary point that I want to address which is the fallacy of the Fed Model.

While there are certainly reasons to be bullish about the financial markets currently, as their hover near historic highs, one of the simplest, most overused and popular assertions is that claim that stocks must rise because interest rates are so low.  In fact, you cannot get through an hour of financial television without hearing someone discuss the premise of the Fed Model which is earnings yield versus bond yields.

The idea here, once formalized as the “Fed Model,” is that stocks’ “earnings yield” (reported or forecast operating earnings for the S&P 500, divided by the index level) should tend to track the Treasury yield in some fashion. 

This simply doesn’t hold up in theory or practice.

First, the Federal Reserve has been on an unprecedented mission to support the financial markets and the economy through outright manipulation of interest rates.  The artificial suppression of interest rates through various interventions, such as Quantitative Easing, has distorted what bond yields would be in a more normal operating environment.  Therefore, the yields do not reflect the inherent risk being undertaken by investors in terms of duration, credit or repayment. 

The Fed’s goal of suppressing interest rates was to ultimately boost employment and asset prices to spur economic growth.  However, the problem for the Fed has been a failed transmission system which has left the “wealth effect” trapped at the upper end of the economic spectrum and has failed to do much more than keep the economy from slipping into a prolonged recession. 


Therefore, with the yield curve artificially steep the effectiveness of the yield curve’s recession predicting capability may be somewhat suspect this time around. This is something I can’t prove at the moment – but I do think that time will tell that this time “may indeed be different.”  However, the reason I state this is that if we extract the influence of trillions of dollars of Federal stimulus though both the government (TARP, HAMP, HARP, etc.) and the Federal Reserve – the yield curve would likely look far different than it does today. 

This brings us to profits and equity yields.  Corporate profits surged since the depths of the financial crisis.  However, as I discussed in our recent post on “The Great Disconnect: Market Vs. Economy”:

“Corporate profits have surged since the end of the last recession which has been touted as a definitive reason for higher stock prices. While I cannot argue the logic behind this case, as earnings per share are an important driver of markets over time, it is important to understand that the increase in profitability has not come strong increases in revenue at the top of the income statement. As the chart below shows while earnings per share has risen by over 200% since the beginning of 2009 – revenues have grown by less than 10%.


As expected, since the economy is 70% driven by personal consumption, GDP growth and revenues have grown at roughly equivalent rates. Therefore, the question as to where corporate profitability came from must be answered? That answer can be clearly seen in the chart below of corporate profits per worker which is at the highest level in history.


Suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability. However, these actions are finite in nature and inevitably it will come down to topline revenue growth. However, since consumer incomes have been cannibalized by suppressed wages and interest rates – there is nowhere left to generate further sales gains from in excess of population growth.”

As the Fed’s suppression of interest rates – given a more normal operating environment earnings yields would likely be less than they are today.  The deflationary pressures on wages due to an excessively large labor pool, combined with accounting manipulation and record stock buybacks to boost earnings per share, have inflated the earnings yield to historically high levels.  However, it is also within the context of these “record profits” that a warning bell should be sounding as “records” by any measure are usually more representative of a peak within the current trend rather than the start of one.  

The Fed Model Is Broken

This bring us to the widely followed, overly espoused and internally flawed “Fed Model.”  The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa.  That makes sense – until you actually think about it.

The problem here is twofold. First, you receive actual income from owning a Treasury bond, along with a return of principal function, whereas there is no tangible return from an earnings yield on stocks.  Therefore, if I own a Treasury with a 5% yield and a stock with a 8% earnings yield, if the price of both assets do not move for one year – my net return on bond is 5% and on the stock it is 0%.  Which one had the better return?  This has been especially true over the last decade where stock performance has been significantly trounced by simply owning cash and bonds rather than equities.  Yet, analysts keep trotting out this broken model to entice investors to chase the single worst performing asset class over the last decade.


It hasn’t been just the last decade either with which the “Fed Model” has continually misled investors. An analysis of the previous history of the concept shows it to be a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50’s and 60’s the model actually worked pretty well as economic growth was strengthening.  Interest rates steadily rose as a stronger economic growth allowed for higher rates which enticed higher personal savings rates.  These higher savings rates were lent out by banks into projects that continued further stimulated economic growth. 


However, as I have discussed in the past in “The End Of Keynesian Economics” as the expansion of debt, the shift to a financial and service economy and the decline in savings began to deteriorate economic growth the model no longer functioned. During the biggest bull market in the history of the United States you would have sat idly by in treasuries and watched stock skyrocket higher. However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost a large chunk of your principal after the crash of the markets in 2008.

Currently, you are back in again after missing most of the run up in the current bull cycle only most likely to be left with the four “B’s” after the next recession ends – Beaten, Battered, Bruised and Broke.

The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine “WHAT” to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining “WHEN” to make an investment. In other words, I can buy fundamentally cheap stock all day long; however, if I am buying at the top of a market cycle then I will still lose money.

As with anything in life – half of the key to long term success is timing. Right now, with virtually all of the economic indicators weakening, rising geopolitical tensions, continued concerns from an ongoing recessionary environment in the Eurozone, valuations anything but cheap currently and an extremely overbought and extended market technically – timing right now could not be worse for long term investors to “jump in”.

Could stocks double from here?  Anything is possible, however, for investors the reality is that the current financial and economic environment is not extremely healthy because if it were the Fed would not need to be engaged in two simultaneous liquidity programs to keep it afloat.  Without such support from the Fed, as we have seen after the conclusion of the previous Q.E. programs, the markets, and the economy, would quickly begin to contract.

It’s time for the “Fed Model” to go the way of the “dodo.”  Of course, much like the “Mirror On The Wall” as long as it tells us that we are the “fairest of them all” what could possibly go wrong?


Fed's Fisher: "Too-Big-To-Fail Regulation Should Be Written By A Sixth-Grader"

QE “is not a Buzz Lightyear policy,” Dallas Fed’s Fisher explains to Bloomberg TV’s Stephanie Ruhle, “this will not go on forever.” He admits there are limits to their (and implicitly the ECB or BoJ) policies – “we just have to figure out what they are.” The always outspoken fed head goes on to explain why he believes the Fed’s policy should be “dialed back… Not go from wild turkey, the liquor by the way, to cold turkey; but certainly slowing it down now.” The too-big-to-fail banks are absolutely gaining from a substantial cost-of-funding advantage (over smaller banks) with their implicit government guarantee and Fisher expresses disappointment in the reams of pages that constitute new regulation adding that he would prefer “a simple statement saying they understand there is no government guarantee… It could be written by a sixth grader,” as Dodd-Frank “needs repair.” His fears are exacerbated by Cyprus as he notes, “[in Cyprus] you have an economy that is held hostage by bank failure and institutions that are too big to fail. We cannot let that happen in the U.S. ever again and the American people will not tolerate it.”


Fisher on whether the BOJ’s move puts the ECB or the Fed in a corner where they’ll have to continue QE in order to stay on par:

The rates are already very low in Japan. I think people will want to wait and see how successful the program really is. Does it put pressure on us to continue? No, we have to conduct monetary policy according to what we feel is best to get our economy moving.


There has a consensus on the table to pursue along these lines of quantitative easing. I have voted and spoken against it. There is no QE infinity. I have never heard an argument at the table from anybody that we will take the Fed’s balance sheet to $5 million or whatever number. We already have a very active program. The chairman spoke about this at his press conference. We have to judge the efficacy of what we’re doing and either dial it back or dial it up a little bit. This will not go on forever and ever.


It is not a Buzz Lightyear policy. Neither we nor the ECB nor anyone else can follow that because there are limits and we just have to figure out what those limits are.”

On whether he believes that QE, up until a certain point, was a success:

“I can only speak for myself, not my colleagues. I was in favor of the first tranche of mortgage-backed securities purchases. I am not in favor of continuing that process. I think we have to dial it back. Not go from wild turkey, the liquor by the way, to cold turkey. Certainly slowing it down now. I wasn’t in favor of the second tranche. The housing market has come back significantly… We’ve seen a resurrection in that market and I think Fed policy was very helpful. I’m only giving my position. I think we need to dial that program back. That worked. And it is clearly working from the standpoint of driving up the stock market. It is not yet clear that this has been what has been regenerated, employment to robust degree that we would like to see. It has not happened yet. Corporations have clearly refinanced their balance sheets. Our businesses from a financial standpoint are lean and mean and ripped and strong. But they are not spending it on hiring people.


They are refinancing their debt, bolstering their balance sheets, making acquisitions, and it is too early to argue whether it has been successful or not, in my opinion. It has certainly helped the federal government, by the way. It has helped the federal government significantly.


We are buying so many treasuries now — and I made this argument a long time before it was enormously unpopular. We have been monetizing the debt, and we continue to do so. At some point, we end up taking it all down. I’m not sure that incents the Congress deal what they have to deal with which is correct our fiscal imbalances. That is what I worry about the most.”

On whether he believes that we are subsidizing too-big-to-fail banks right now:

“Absolutely. There is no question about it. There is some debate about what the size of the subsidy is. Bloomberg itself had a long report about being in the $80 billion range. There are numbers higher and less than that. It depends on how you calculate this. I can tell you one thing with certainty. There is a cost of funding advantage and it is substantial. It is unfair. We need to level the playing field. I’m not trying to bust these institutions up.


Our proposal at the Dallas Fed has been very simple: limit the taxpayer’s liability to covering the deposit base, and making sure through that government guarantee, which is what we do in this country and only allowing the commercial banking operation of a large complex bank holding company to have access to the discount window.


The rest of their operations would be totally free standing that each counterparty to those operations, whatever the transaction may be, would sign a simple statement saying they understand there is no government guarantee. It would be agreed upon by both sides. We have drafted it up and shown it. It could be written by a sixth grader. It would make clear that no one would expect the government to step in for the risk taken in those areas…Yes, they currently being subsidized…It puts the smaller banking institutions at a competitive disadvantage and that is not the American way.”

On why he believes that it’s up to Congress, not regulators, to create new incentives so market discipline is restored to the banking industry:

“You are talking about Dodd-Frank, which does not work and in its preamble its outstated purpose was to stop too big to fail because congress makes the laws of the United States. They make the regulations that we as regulators have to follow. And right now, the Federal Reserve and others under the leadership of Dan Tarullo, one of our governors, is doing our absolute best to follow what is prescribed by Dodd-Frank. I’m not a critic of what we’re doing. We’re doing our very best to follow the law, but regulations have to be made and only Congress can make it.”

On whether Dodd-Frank should just be scrapped entirely:

“I would not go that far, but I’d think it needs repair. We have advocated a small repair…All we are trying to do at the Dallas Fed is that we do not want to do this again. Cyprus is a great example, once again, as we saw in Iceland, of banks that jeopardize their entire country. We cannot let that happen. We can deal with this now that our financial institutions have been restored and the economy is moving forward. We’re not a crisis situation like we were before. And to be fair to Dodd-Frank, it was forged in the crucible of a crisis.”

On whether he’s likening the situation in Cyprus to the situation that the U.S. could face if Dodd-Frank isn’t repaired:

“No, I’m not. I’m saying that to solve a problem during a crisis is a lot harder than when you’re on a level plane. That’s where we are right now thanks to Fed policy and other actions that have been taken. We can deal with this now. There is bipartisan accord that too big to fail has not been solved. There is bipartisan agreement, and even the attorney general admitted he is afraid to prosecute these large institutions for whatever their misdeeds are because it might create economic damage. The problems are still there. Now that we are in economic recovery, we can deal with the problem. It is a different situation. The reason I mention Cyprus is because you have an economy that is held hostage by bank failure and institutions that are too big to fail. We cannot let that happen in the U.S. ever again and the American people will not tolerate it, so let’s solve it.”


Kyle Bass: "Japan Will Implode Under Weight Of Their Debt"

As the fast-money flabber-mouths stare admiringly at the rise in nominal prices of Japanese (and the rest of the world ex-China) stock prices amid soaring sales of wheelbarrows following Kuroda’s ‘shock-and-awe’ last night, it is Kyle Bass who brings these surrealists back to earth with some cold-hard-facting. Out of the gate Bass explains the massive significance of what the Japanese are embarking on, “they are essentially doubling the monetary base by the end of 2104.”

It is a “Giant Experiment,” he warns, but when you are backed into a corner and your debts are north of 20 times your government tax revenue, “you’re already insolvent.” Simply put, Bass says they have to do something and they have to something big because they are “about to implode under the weight of their debt.” For a sense of the scale of the BoJ’s ‘experimentation’, Bass sums it up perfectly (and concerningly), “the BoJ is monetizing at a rate around 75% of the Fed on an economy that is one-third the size of the US!”

What they are trying to do is devalue the currency to attempt to become more competitive while holding their rates market flat – the economic zealots running the world’s central banks believe they can live in that Nirvana – and Bass believes that is not the case, as they will lose control of rates, since leaving the zone of insolvency is impossible now. His advice, “if you’re Japanese, spend! or take it out of your country. If you’re not, borrow in JPY and invest in productive assets.” Do not be long JPY or Japanese assets as he concludes with the reality of Japan’s “hollowed out” manufacturing industry and why USDJPY is less important that KRWJPY.




CME Hikes Yen, Nikkei Futures Margins By 19%-33%

Two years ago, warning of a bubble in gold/silver/PMs was all the rage. Luckily, those days are long gone, allowing one to accumulative hard assets in peace, in a declining paper price environment, without the thundering herd in the rearview mirror. Nowadays, the ever-“vigilant” mainstream media has moved on, and has been so very observent to spot a new bubble in bitcoins. As we always do, we decided to have some fun at the MSM’s expense, and tweeted the following earlier today:

USDJPY showing Bitcoin who is boss in category of parabolic moves today

— zerohedge (@zerohedge) April 4, 2013

It appears the CME heard us, and moments ago proceeded to hike margins across the entire Yen future spectrum by anywhere between 19% and 33%.

Among the products whose margins just shot up are Yen Futures, the E-Mini and Micro Yen, as well as AJ, BY and CY. And just so it was clear that according to the CME the next bubble forming is in all things Nikkei related, it also hiked by 25% margins in the E-Mini Nikkei 225 Yen Denominated contract, as well as the plain vanilla Nikkei 225 and the N1 futures.

So the CME has now spoken. How long until it is forced to unwind its margin hike after it is made clear to it that in the pursuit of the global ‘wealth effect’ all is fair and forgiven. Especially, now that it has been made very clear to Japan that after 30 years of deflation, all the country had to do to get “wealthy” was print 15% of its GDP each year in new money…


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