When yields on the 10 Year Treasury note were climbing to 4.0% last spring bond traders fears were focused three items: the Federal Reserve’s liquidity provisions, the Obama administration’s ten year deficit projections and the inflationary potential of both programs. The collapse in Treasury prices prompted the Fed’s entry into the Treasury market. Its $300 billon program to purchase government debt led to suspicions that the US Government had embarked on direct monetization of its debt, printing dollars to make up for the revenues it no longer had. As the Treasury began to auction its debentures these fears undermined confidence that investors would accept the new issuance at market rates.
China and Russian were the most vocal about the danger to their American investments from a collapsing dollar but the risk applied to all holders of US notes. The Chinese and the Russians outlined their concerns in clear and unsusually plain language. Chinese officials warned the US government to be mindful of its status as the world's largest holder of US debt and cautioned Washington to act as a careful custodian of its currency. The Russian were blunter, calling for a new world reserve currency to replace the dollar.
If the debt markets did not readily buy American notes because of worries about the US dollar, American bond rates would be forced higher dragging mortgage and other US rates with them. The US government’s efforts to limit the economic damage of the financial crisis and recession would be far less effective with higher mortgage and credit card rates. Few economists and officials then thought the American economy could tolerate a substantial rise in rates.
But rhetoric aside, the Chinese had reasons of their own to fear what would have been a dangerous fall in the Treasury markets and the consequent rise in American interest rates.
China depends on the world’s economy to buy her exports. If the US Treasury markets had cratered in the spring the effect on the US economy and the world could have been catastrophic. In the frightened atmosphere last spring that risk was very high.
At the very least a collapse in the Treasury market would have heightened the sense of disaster that was just beginning to ebb, seriously deepened the recession and hastened the decline in world trade. In that febrile atmosphere a Chinese withdrawal from the US Treasury markets would have had global effects.
Chinese exports contracted dramatically in the late fall, winter and early spring. Factories closed, millions of migrant workers to the cities were thrown out of work bringing with them the specter of civil unrest which is never far from the minds of the rulers in Beijing.
When the US began its Treasury auctions China’s immediate self interest kept her actively involved. As the most visible of the world’s governments participating in the Treasury market any sign of actual withdrawal, as opposed to theoretical criticism, would have had a dire effect on the worldwide appetite for US debt.
China clearly had and has a present interest in keeping the US Treasury market from sinking and in keeping US rates low and the US economy on track for the strongest recovery possible. But there is also a long term Chinese interest in fostering the US debt binge.
The Obama administration has embarked on the largest expansion of US debt in history. Its legislative plans include the greatest addition to government services since the Depression. Such a program cannot be accomplished without the cooperation of the world’s credit markets; the leading buyers of US debt are other governments with China paramount. If China does not acquiesce to the increase in US debt the administration will have a much harder time enacting its plans. The most likely political result in Washington would be a curtailment of US Government spending and a drop in the amount of debt that the Treasury would have to issue.
But if the administration is able to complete its economic agenda the result will be an enormous increase of US debt and eventually higher taxes to pay for those programs and the debt.
The exaction that this debt will take from the US economy in lower productivity and economic growth will permanently alter the position of the US economy in the world. If the administration completes its agenda then the dollar will decline, slowly but inexorably, as the US economy slips from its position as the most vibrant mature industrial economy and loses it position as the world's largest national economy.
The possibility for a devaluation of Chinese dollar holding is very real but perhaps Beijing considers it a down payment on the future. Would it not be a worthy price to pay for assisting the self-imposed crippling of her greatest economic competitor?
Joseph Trevisani
Tuesday, September 22, 2009
Tuesday, September 15, 2009
Market Direction
The yen carry trade was one of the great runs in modern currency history. A long position opened in late in late 2003 and held until mid-2007 appreciated over 30% in capital and could have earned upwards of 7% a year on the interest rate spread. At the trade’s height from mid-2005 until the summer of 2007 the trajectory of yen crosses rose with barely a correction.
Japanese rates in that period never rose above 0.5%. The worldwide lure of yen funding was not only the extremely low cost of money but the knowledge that the Bank of Japan (BOJ) could not raise rates.
Interest rates in the United States are the equivalent of the zero rate policy in Japan. If the Fed cannot raise rates because of anemic US economic growth will the dollar replace the yen as the world funding currency?
The extended period of effective zero interest rates in Japan was the financial rationale for the carry trade. But low interest rates alone did not account for the longevity of the yen carry trade. Long positioning in the carry returned the rate differential and trading interest and easy credit for speculators kept the crosses moving higher. But equally important was the trap that the Japanese economy held for the BOJ. The Japanese central bank could not raise rates. The performance of the Japanese economy since 1989 and her political reality precluded it. Currency traders enjoyed a more than reasonable conviction that whatever BOJ officials might say Japanese rates would stay low.
Japan’s lost decade began in late 1989 when the Bank of Japan sharply raised interest rates to combat a credit fueled bubble in the property and stock markets. Both markets crashed. Twenty years later neither have regained the prices of that decade. But having engineered the calamity the Japanese government did not insist on the rationalization of insolvent banks and industrial companies. Banks were kept alive with government aid and falling companies were supported by bank loans and subsidies. Economic growth ground to a halt.
From 1995 onward the main Japanese interest rate set by the Bank of Japan was never higher than 0.5%. But the extremely low rates did not spur economic growth. The zero rate policy which the bank began in 2001 to counter price deflation and foster economic activity accomplished neither goal.
It was the boom years of the world economy in the middle part of this decade and the external demand for Japanese goods that dragged the export dominated Japanese economy out of its self-inflicted doldrums. With the collapse in world demand last year the Japanese economy was again trapped by its export model. Fifteen years of massive government spending and little economic reform has only succeeded in raising the Japanese debt level to the highest in the industrial world without building a solid domestic base of consumption. Japan’s lost decade could well become permanent if world demand for Japanese products does not recover
In order for the dollar to become the world’s long term funding currency, as the yen was for the better part of the decade, low interest rates are not sufficient. Markets must also become convinced that US rates will stay low for a prolonged period; that period is probably well beyond the horizon currently implied by Fed Chairman Bernanke. Whatever the problems of the American economy markets are far from convinced that a ten year Japanese economic morass awaits the United States.
The currency reaction to the financial crisis and its logic has been well documented. Overnight the dollar and the United States Government became the repository of much of the world’s portable risk capital. The majority of that temporary capital infusion has now left the US seeking investment elsewhere in the world.
The Federal Reserve response to the sub-prime housing problem began two years ago in September 2007 when it cut rates 0.5%. Since then the Fed has taken US rates effectively to zero and supplied enormous amounts of liquidity to the economy, initially to stave off economic collapse and subsequently to secure economic growth.
But the US economy, despite massive losses in property and equities and continuing job destruction, is not facing the economic stasis of Japan’s lost decade
The US economy is larger and more diverse than Japan's. Exports do not dominate the economy. The US population is growing and domestic consumption is the bulk of GDP. The US financial and economic system is far less controlled by the central government and economic rationalization of banks and companies is taking place. The US will probably not have a large number of companies kept alive with permanent government subsidies. In short the US economy is still expected to recover and to grow next year. The Fed will not have to keep rates below 0.5% for a decade. Far more likely is a Fed rate hike cycle beginning in late 2010 or 2011.
The dollar will not become the new world funding currency as long as the US economy performs within a range of its historical potential. If traders thought there was a good chance that the Fed would be forced to emulate the BOJ zero rate policy for a decade then the dollar would already have seen far heavier losses than it has.
Traders are not yet betting on a lost decade in the US. Until they do the dollar will be a funding currency only until the Fed first hints at higher rates The world will borrow cheaply in the US as long as it can, but there will be no five year carry trade punishing the dollar, at least not yet.
Joseph Trevisani
Japanese rates in that period never rose above 0.5%. The worldwide lure of yen funding was not only the extremely low cost of money but the knowledge that the Bank of Japan (BOJ) could not raise rates.
Interest rates in the United States are the equivalent of the zero rate policy in Japan. If the Fed cannot raise rates because of anemic US economic growth will the dollar replace the yen as the world funding currency?
The extended period of effective zero interest rates in Japan was the financial rationale for the carry trade. But low interest rates alone did not account for the longevity of the yen carry trade. Long positioning in the carry returned the rate differential and trading interest and easy credit for speculators kept the crosses moving higher. But equally important was the trap that the Japanese economy held for the BOJ. The Japanese central bank could not raise rates. The performance of the Japanese economy since 1989 and her political reality precluded it. Currency traders enjoyed a more than reasonable conviction that whatever BOJ officials might say Japanese rates would stay low.
Japan’s lost decade began in late 1989 when the Bank of Japan sharply raised interest rates to combat a credit fueled bubble in the property and stock markets. Both markets crashed. Twenty years later neither have regained the prices of that decade. But having engineered the calamity the Japanese government did not insist on the rationalization of insolvent banks and industrial companies. Banks were kept alive with government aid and falling companies were supported by bank loans and subsidies. Economic growth ground to a halt.
From 1995 onward the main Japanese interest rate set by the Bank of Japan was never higher than 0.5%. But the extremely low rates did not spur economic growth. The zero rate policy which the bank began in 2001 to counter price deflation and foster economic activity accomplished neither goal.
It was the boom years of the world economy in the middle part of this decade and the external demand for Japanese goods that dragged the export dominated Japanese economy out of its self-inflicted doldrums. With the collapse in world demand last year the Japanese economy was again trapped by its export model. Fifteen years of massive government spending and little economic reform has only succeeded in raising the Japanese debt level to the highest in the industrial world without building a solid domestic base of consumption. Japan’s lost decade could well become permanent if world demand for Japanese products does not recover
In order for the dollar to become the world’s long term funding currency, as the yen was for the better part of the decade, low interest rates are not sufficient. Markets must also become convinced that US rates will stay low for a prolonged period; that period is probably well beyond the horizon currently implied by Fed Chairman Bernanke. Whatever the problems of the American economy markets are far from convinced that a ten year Japanese economic morass awaits the United States.
The currency reaction to the financial crisis and its logic has been well documented. Overnight the dollar and the United States Government became the repository of much of the world’s portable risk capital. The majority of that temporary capital infusion has now left the US seeking investment elsewhere in the world.
The Federal Reserve response to the sub-prime housing problem began two years ago in September 2007 when it cut rates 0.5%. Since then the Fed has taken US rates effectively to zero and supplied enormous amounts of liquidity to the economy, initially to stave off economic collapse and subsequently to secure economic growth.
But the US economy, despite massive losses in property and equities and continuing job destruction, is not facing the economic stasis of Japan’s lost decade
The US economy is larger and more diverse than Japan's. Exports do not dominate the economy. The US population is growing and domestic consumption is the bulk of GDP. The US financial and economic system is far less controlled by the central government and economic rationalization of banks and companies is taking place. The US will probably not have a large number of companies kept alive with permanent government subsidies. In short the US economy is still expected to recover and to grow next year. The Fed will not have to keep rates below 0.5% for a decade. Far more likely is a Fed rate hike cycle beginning in late 2010 or 2011.
The dollar will not become the new world funding currency as long as the US economy performs within a range of its historical potential. If traders thought there was a good chance that the Fed would be forced to emulate the BOJ zero rate policy for a decade then the dollar would already have seen far heavier losses than it has.
Traders are not yet betting on a lost decade in the US. Until they do the dollar will be a funding currency only until the Fed first hints at higher rates The world will borrow cheaply in the US as long as it can, but there will be no five year carry trade punishing the dollar, at least not yet.
Joseph Trevisani
Wednesday, September 9, 2009
Market Direction
One of the most surprising developments of the financial crisis and recession has been the continued strength of the Japanese Yen.
The return of relative stability to the world financial system has not prevented the yen from retaining the majority of its crisis induced advances. The Japanese currency has held onto 75% of its gains against the dollar, 65% versus the euro, 60% from the aussie and 75% from the sterling. In comparison the dollar has retained only 47% of its euro gain, 33% of its aussie improvement and 56% of its sterling take.
From its pre-crisis lows late last summer the yen appreciated 21% against the dollar, 34% against the euro, 47% versus the aussie and 53% opposed to the pound. The dollar also improved dramatically, gaining 23% against the euro, 39% versus the Australian Dollar and 32% against the pound.
But the dollar has since given back a substantial portion of its gains keeping only an 11% improvement against the euro, 13% to the aussie and 18% against the pound. The yen however has remained potent. It is still 16% stronger against the dollar, 22% stronger against the euro, 24% versus Australian Dollar and 39% against the pound.
The dollar and the yen were the only major currencies that strengthened during the crisis and that alone gave de facto status to each as a safe haven currency. But as the dislocations in the financial system have lessened so has the safe haven benefit to the dollar. Not so, or not nearly so much, for the yen. Why has the Japanese currency retained more of its crisis enhanced quality?
At the height of the crisis enormous quantities of American investments, primarily Treasuries were purchased by panicked investors. The demand for dollars to buy those US instruments was one of the driving forces behind the greenback’s ascent. But as the acute phase of the crisis has ebbed, the funds placed in the safety of T-Bills, Notes and Bonds have gradually left the United States seeking more remunerative investments elsewhere.
The effect on the dollar has been plain and predictable. Close to half of its crisis gains have been lost. The rationale for the dollar’s rise and fall in response to the financial crisis has been logical, determined by the balance between the need for safety and earning, risk and return.
If the rise in the yen was due to the same influx of safety seeking funds, one explanation for the subsequent stability of the yen could be that the owners of those funds find in Japan a congenial investment environment. Let us look at some of the possibilities.
Perhaps investors expect the Japanese economy to recover earlier than the United States or Europe. Japan is still the second largest economy in the world and its position in Asia and as a supplier to China, the largest industrial country to sustain strong economic growth, could help restore the Japanese economy. But in reality the Japanese economy has been underperforming for more than a 15 years, throughout the economic rise of China. Japanese decline is largely due to internal factors, including expensive and protected consumer and agricultural sectors, bureaucratic and regulatory control of much of the economy, pointless and never ending domestic spending and a stultified political system that inhibited most change.
Then perhaps the victorious Democratic Party of Japan (DPJ) will be able to revive the economy and move the country into the 21st century?
But the policy prescriptions of the DPJ do not give the impression of de-regulatory pro-growth, consumer centered plans for Japan’s economy. Japanese public debt is the highest in the industrialized world at 170% of GDP. Yet the election platform of the DPJ, with its Keynesian emphasis on government spending and its vaguely anti-capitalist and anti-globalization stances seems particularly ill-suited to revive the world’s largest export dependant economy.
When the vagueness of the DPJ economic policies is coupled with the inexperience of their legislators and the opposition of the experienced and entrenched bureaucrats that really run the Japanese economy the promise for reform and restoration becomes even more problematic. It is very hard to discern a positive yen aspect from the DPJ policies themselves or from the movements of the yen in the currency markets over the past several months as the DPJ victory became almost certain.
If the prospects for the Japanese economy have not fortified the yen then perhaps the currency has been supported by its ostensible role as a proxy trade for the Chinese Yuan?
When the financial crisis struck the Beijing Government ended the managed appreciation of the yuan; it has been static against the dollar since last fall. It has been surmised that the yen has played a substitute role to the Chinese currency with traders keeping long positions in the yen as a replacement for the unavailable yuan. And while it is true that the end of yuan appreciation and the advent of yen strength coincide, it is more likely that the proxy currencies for the yuan are the Australian and New Zealand Dollars, which have had strong upward moves largely tied to the success of the Chinese economic stimulus.
If the strong yen is not a harbinger of an economically recovered Japan and if its yuan proxy quality is limited, the remaining reasons behind its supposed safe haven status become even more relevant and interesting.
The idea of the yen as a safe haven currency can be ascribed to two factors. First the likelihood of Japanese default is very low and when tied to Japan’s recent history of deflation Japanese bonds provide the investor with safety of funds and currency stability. That was also the default position of the dollar and its issuer the United States Federal government. Both currencies scored highly in the financial crisis.
The second factor applies only to the yen and might be called the empirical choice. By any measured judgment the yen is an unusual choice for a safe haven currency. Except for the unity of the Japanese political system, most other economic and interest rate factors would seem to be against it. The Japanese economy has performed dismally over the past 15 years and Japan has one of the oldest and most quickly declining populations in the world. Its potential for economic growth seems quite limited.
But the financial crisis played a stronger hand than comparative economics. The worldwide collapse in interest rates destroyed the rationale for the carry trade. The result was a vastly strengthened yen because the attendant trade to the selling of the yen crosses was the panic buying of the yen against the US Dollar. As the carry trade loans came home to Japan and the speculative positions in the yen crosses vanished with the credit lines of the hedge funds the yen was bought extensively but only to close existing positions. In other words once the loans and trade positions were covered there was far less speculative positioning against the yen than would be found in a normal market.
The equation of a stronger yen with financial turmoil was not due to the inherent strength and security of the Japanese economy but to the bubble markets in the carry trade and yen funding. The yen did not rise because traders sought the safety of Japanese investments. The yen rose because the currency markets were overwhelmed by the unwinding of the carry trade and yen funding positions.
But from an empirical view the yen appreciation coincided perfectly with the deepening of the financial crisis. It certainly appeared that the yen was being sought as a safe haven currency. And since the yen had strengthened it was, in fact if not in economic logic, a safe haven currency.
Yen strength, to borrow a phrase, prospered in a fit of absence of mind. The tremendous force of the deleveraging carry trade raised the yen to its current heights. But those forces were one way, buying the yen to close shorts but not opening new long positions.
The yen was not truly a safe haven currency during the financial crisis. With the ending of the crisis the yen has not returned to pre-crisis trading levels. The evidence that there were few safe haven flows into the yen is simple; none have left Japan to weaken the yen.
In the US, a true safe haven during the crisis, the flows that entered during the crisis have now largely left. The dollar was boosted by the flows in and declined as they left. The lack of that second move out of Japan and the yen means that the forces pushing up the yen last fall were not seeking safety in Japanese bonds. The yen was a safe haven only by a trading default of the yen crosses.
The return of relative stability to the world financial system has not prevented the yen from retaining the majority of its crisis induced advances. The Japanese currency has held onto 75% of its gains against the dollar, 65% versus the euro, 60% from the aussie and 75% from the sterling. In comparison the dollar has retained only 47% of its euro gain, 33% of its aussie improvement and 56% of its sterling take.
From its pre-crisis lows late last summer the yen appreciated 21% against the dollar, 34% against the euro, 47% versus the aussie and 53% opposed to the pound. The dollar also improved dramatically, gaining 23% against the euro, 39% versus the Australian Dollar and 32% against the pound.
But the dollar has since given back a substantial portion of its gains keeping only an 11% improvement against the euro, 13% to the aussie and 18% against the pound. The yen however has remained potent. It is still 16% stronger against the dollar, 22% stronger against the euro, 24% versus Australian Dollar and 39% against the pound.
The dollar and the yen were the only major currencies that strengthened during the crisis and that alone gave de facto status to each as a safe haven currency. But as the dislocations in the financial system have lessened so has the safe haven benefit to the dollar. Not so, or not nearly so much, for the yen. Why has the Japanese currency retained more of its crisis enhanced quality?
At the height of the crisis enormous quantities of American investments, primarily Treasuries were purchased by panicked investors. The demand for dollars to buy those US instruments was one of the driving forces behind the greenback’s ascent. But as the acute phase of the crisis has ebbed, the funds placed in the safety of T-Bills, Notes and Bonds have gradually left the United States seeking more remunerative investments elsewhere.
The effect on the dollar has been plain and predictable. Close to half of its crisis gains have been lost. The rationale for the dollar’s rise and fall in response to the financial crisis has been logical, determined by the balance between the need for safety and earning, risk and return.
If the rise in the yen was due to the same influx of safety seeking funds, one explanation for the subsequent stability of the yen could be that the owners of those funds find in Japan a congenial investment environment. Let us look at some of the possibilities.
Perhaps investors expect the Japanese economy to recover earlier than the United States or Europe. Japan is still the second largest economy in the world and its position in Asia and as a supplier to China, the largest industrial country to sustain strong economic growth, could help restore the Japanese economy. But in reality the Japanese economy has been underperforming for more than a 15 years, throughout the economic rise of China. Japanese decline is largely due to internal factors, including expensive and protected consumer and agricultural sectors, bureaucratic and regulatory control of much of the economy, pointless and never ending domestic spending and a stultified political system that inhibited most change.
Then perhaps the victorious Democratic Party of Japan (DPJ) will be able to revive the economy and move the country into the 21st century?
But the policy prescriptions of the DPJ do not give the impression of de-regulatory pro-growth, consumer centered plans for Japan’s economy. Japanese public debt is the highest in the industrialized world at 170% of GDP. Yet the election platform of the DPJ, with its Keynesian emphasis on government spending and its vaguely anti-capitalist and anti-globalization stances seems particularly ill-suited to revive the world’s largest export dependant economy.
When the vagueness of the DPJ economic policies is coupled with the inexperience of their legislators and the opposition of the experienced and entrenched bureaucrats that really run the Japanese economy the promise for reform and restoration becomes even more problematic. It is very hard to discern a positive yen aspect from the DPJ policies themselves or from the movements of the yen in the currency markets over the past several months as the DPJ victory became almost certain.
If the prospects for the Japanese economy have not fortified the yen then perhaps the currency has been supported by its ostensible role as a proxy trade for the Chinese Yuan?
When the financial crisis struck the Beijing Government ended the managed appreciation of the yuan; it has been static against the dollar since last fall. It has been surmised that the yen has played a substitute role to the Chinese currency with traders keeping long positions in the yen as a replacement for the unavailable yuan. And while it is true that the end of yuan appreciation and the advent of yen strength coincide, it is more likely that the proxy currencies for the yuan are the Australian and New Zealand Dollars, which have had strong upward moves largely tied to the success of the Chinese economic stimulus.
If the strong yen is not a harbinger of an economically recovered Japan and if its yuan proxy quality is limited, the remaining reasons behind its supposed safe haven status become even more relevant and interesting.
The idea of the yen as a safe haven currency can be ascribed to two factors. First the likelihood of Japanese default is very low and when tied to Japan’s recent history of deflation Japanese bonds provide the investor with safety of funds and currency stability. That was also the default position of the dollar and its issuer the United States Federal government. Both currencies scored highly in the financial crisis.
The second factor applies only to the yen and might be called the empirical choice. By any measured judgment the yen is an unusual choice for a safe haven currency. Except for the unity of the Japanese political system, most other economic and interest rate factors would seem to be against it. The Japanese economy has performed dismally over the past 15 years and Japan has one of the oldest and most quickly declining populations in the world. Its potential for economic growth seems quite limited.
But the financial crisis played a stronger hand than comparative economics. The worldwide collapse in interest rates destroyed the rationale for the carry trade. The result was a vastly strengthened yen because the attendant trade to the selling of the yen crosses was the panic buying of the yen against the US Dollar. As the carry trade loans came home to Japan and the speculative positions in the yen crosses vanished with the credit lines of the hedge funds the yen was bought extensively but only to close existing positions. In other words once the loans and trade positions were covered there was far less speculative positioning against the yen than would be found in a normal market.
The equation of a stronger yen with financial turmoil was not due to the inherent strength and security of the Japanese economy but to the bubble markets in the carry trade and yen funding. The yen did not rise because traders sought the safety of Japanese investments. The yen rose because the currency markets were overwhelmed by the unwinding of the carry trade and yen funding positions.
But from an empirical view the yen appreciation coincided perfectly with the deepening of the financial crisis. It certainly appeared that the yen was being sought as a safe haven currency. And since the yen had strengthened it was, in fact if not in economic logic, a safe haven currency.
Yen strength, to borrow a phrase, prospered in a fit of absence of mind. The tremendous force of the deleveraging carry trade raised the yen to its current heights. But those forces were one way, buying the yen to close shorts but not opening new long positions.
The yen was not truly a safe haven currency during the financial crisis. With the ending of the crisis the yen has not returned to pre-crisis trading levels. The evidence that there were few safe haven flows into the yen is simple; none have left Japan to weaken the yen.
In the US, a true safe haven during the crisis, the flows that entered during the crisis have now largely left. The dollar was boosted by the flows in and declined as they left. The lack of that second move out of Japan and the yen means that the forces pushing up the yen last fall were not seeking safety in Japanese bonds. The yen was a safe haven only by a trading default of the yen crosses.
Subscribe to:
Comments (Atom)