Will Japan be the first to test the limits of quantitative easing?

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Macro Letter – No 57 – 24-06-2016

Will Japan be the first to test the limits of quantitative easing?

  • The Bank of Japan made its first provision against losses from QQE
  • As the JPY has strengthened the Nikkei 225 has fallen more than 16% YTD
  • Domestic institutions have been switching from bonds to stocks
  • Japanese share buy backs are on the rise

The Japanese stock market peaked in December 1989, marking the end of a period of economic expansion which briefly saw Japan eclipse the USA to become the world’s largest economy. Since its zenith, Japan has struggled. I wrote about this topic, in relation to the economic reform package dubbed Abenomics, in my first Macro Letter – Japan: the coming rise back in December 2013:-

As the US withdrew from Japan the political landscape became dominated by the LDP who were elected in 1955 and remained in power until 1993; they remain the incumbent and most powerful party in the Diet to this day. Under the LDP a virtuous triangle emerged between the Kieretsu (big business) the bureaucracy and the LDP. Brian Reading (Lombard Street Research) wrote an excellent, and impeccably timed, book entitled Japan: The Coming Collapse in 1989. By this time the virtuous triangle had become, what he coined the “Iron Triangle”.

Nearly twenty five years after the publication of Brian’s book, the” Iron Triangle” is weaker but alas unbroken. However, the election of Shinzo Abe, with his plan for competitive devaluation, fiscal stimulus and structural reform has given the electorate hope. 

In the last two years Abenomics has delivered some transitory benefits but, as this Japan Forum on International Relations – No. 101: Has Abenomics Lost Its Initial Objective? describes, it may have lost its way:-

The key objective of Abenomics is a departure from 20 year deflation. For this purpose, the Bank of Japan supplied a huge amount of base money to cause inflation, and carried out quantitative and qualitative monetary easing so that consumers and businesses have inflationary mindsets. This “first arrow” of Abenomics was successful to boost corporate profits and raising stock prices by devaluing the exchange rate, but falling oil price makes it unlikely to achieve a 2% inflation rate, despite BOJ Governor Haruhiko Kuroda’s dedicated effort. The quantitative and qualitative monetary easing will not accomplish the core objective.

Another reason for such a huge amount of base money supply is to expand export through currency depreciation and to stimulate economic growth, but that has neither boosted export nor contributed to economic growth. We cannot dismiss world economic downturn, notably in China, but actually, Japanese big companies that lead national export, have shifted their business bases overseas during the last era of strong yen. From this point of view, I suspect that the Japanese government overlooked such structural changes that deterred export growth, even if the yen was devalued. The “second arrow” is flexible fiscal expenditure to support the economy, and the result of which has revealed that it is virtually impossible to keep the promise to the global community to achieve the equilibrium of the primary balance in 2020.

In view of the above changes, I would like to lay my hopes on the “third arrow” of economic growth strategy. The growth strategy has been announced three times up to now, in 2013, 2014, and 2015, respectively. The strategy in 2013 launched three action plans, but they were insufficient. The 2014 strategy was highly evaluated internationally, as it actively involved in the reform of basic nature of the Japanese economy, such as capital market reform, agricultural reform, and labor reform. But it takes ten to twenty years for a structural reform like this to work. Meanwhile, it is quite difficult to understand the growth strategy approved by the cabinet in June 2015. Frankly, this is empty and the quality of it has become even poorer. Abenomics was heavily dependent on monetary policy, and did not tackle long term issues so much, such as social security and regional development. However, people increasingly worry about dire prospects of long term problems like 2 population decrease, aging, and so forth, while the administration responds to such trends with mere slogans like “regional revitalization” and “dynamic engagement of all citizens”. But it is quite unlikely that these “policies” will really revitalize the region, or promote dynamic engagement by the people.

The Bank of Japan (BoJ) has held up its side of the bargain but the “Third Arrow” of structural reform seems to be stuck in the quiver. It is prudent, in light of this policy failure, for the BoJ to look ahead to the time when they are required by the government or forced by the markets, to unwind QQE. Last month they began that process.

As this article from the Nikkei Asian Review – BOJ seen preparing for exit from easing with reserves  explains, the BoJ has made a provision of JPY 450bln for the year ending March 2016 against potential capital losses which might be incurred upon liquidation of their JGB holdings. This is the first provision of its kind and substantially reduces the percentage of seigniorage profits remitted to the Japanese government.  The level of remittances has been falling –from JPY 757bln in 2014 to JPY 425bln last year. As at the end of May 2016 the BoJ held JPY 319.5trln of JGBs – 36.6% of outstanding issuance. Japan Macro Advisors estimate this will reach 49.3% by the end of 2017. This year’s provision, whilst prudent, is a drop in the ocean. Under the current Quantitative and Qualitative Easing (QQE) programme they are obligated to purchase JPY 80tln per annum. The Association of Japanese Institutes of Strategic Studies – The Fiscal Costs of Unconventional Monetary Policy put it like this:-

It is quite likely that quantitative easing through high-volume purchases of long-term bonds will cause the Bank of Japan enormous losses over the medium to long term, imposing burdens on taxpayers both directly and indirectly. If the current quantitative easing continues, the Bank of Japan may find itself in the near future unable to cover such losses even using all of its seigniorage profits.

…The BoJ’s seigniorage will be roughly equivalent in present value to the balance of banknotes issued. If the BoJ procures funds by issuing cash at a zero interest rate and purchases JGBs, the present discounted value of the principal and interest earned by the BoJ from its JGBs will equal the balance of banknotes. If interest rates are about 2%, Japan’s demand for banknotes will fall from 19% of GDP at present to less than 10% of GDP, and the BoJ’s aforementioned losses would even exceed the present value of its seigniorage.

Here is an extract from the BoJ’s 16th June Statement on Monetary Policy the emphasis is mine:-

Quantity Dimension: The guideline for money market operations

The Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period:[Note 1]

The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

Quality Dimension: The guidelines for asset purchases

With regard to the asset purchases, the Bank decided, by an 8-1 majority vote, to set the following guidelines:[Note 1]

a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen. With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years.

b) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at annual paces of about 3.3 trillion yen1 and about 90 billion yen, respectively.

c) As for CP and corporate bonds, the Bank will maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

Interest-Rate Dimension: The policy rate

The Bank decided, by a 7-2 majority vote, to continue applying a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.[Note 2]

[Note 1] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. T. Sato, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Kiuchi. Mr. T. Kiuchi proposed that the Bank conduct money market operations and asset purchases so that the monetary base and the amount outstanding of its JGB holdings increase at an annual pace of about 45 trillion yen, respectively. The proposal was defeated by a majority vote.

[Note 2] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Sato and Mr. T. Kiuchi. Mr. T. Sato and Mr. T. Kiuchi dissented considering that an interest rate of 0.1 percent should be applied to current account balances excluding the amount outstanding of the required reserves held by financial institutions at the Bank, because negative interest rates would impair the functioning of financial markets and financial intermediation as well as the stability of the JGB market.

The decision by the BoJ not to increase QQE at its last two meetings has surprised the markets and lead to a further strengthening of the JPY. Governor Kuroda, gave a speech Keio University on June 20thOvercoming Deflation: Theory and Practice in which he described the history of BoJ policy in its attempts to stimulate the Japanese economy:-

As mentioned, the aim of QQE is to overcome the prolonged deflation that has gripped Japan. Even if this deflation has been mild, the fact that it has continued for more than 15 years means that its cumulative costs have been extremely large. Looked at in terms of the price level, an annual inflation rate of minus 0.3 percent over a period of 15 years implies that the price level will fall by around 5 percent, but an annual inflation rate of 2 percent over a period of 15 years means that the price level will rise by around 35 percent.

It is worth noting that the UK and USA was subject to a long period of deflation during the “Great Depression” between 1873 and 1896 (approximately -2% per annum) by this comparison Japan’s experience has been very mild indeed. The BoJ has a 2% inflation target, however, so we should anticipate more QQE. Kuroda-san, who has previously stated that the effect of NIRP will take time to feed through and that NIRP may be increased from -0.1% to -0.5%, gave no indication as to what the BoJ may do next; although he did say that Japan provides an interesting case study for academia.

On June 8th Professor George Selgin delivered the Annual IEA Hayek Memorial Lecture – Price Stability and Financial Stability without Central Banks – lessons from the past for the future in which he discussed good and bad deflation together with “Free Banking” – the concept of financial stability without central banks (if you have 45 minutes and enjoy economic history, the whole speech it is well worthwhile). With regard to the current situation in Japan – and elsewhere – he highlights the different between good deflation which is driven by supply expansion and bad deflation which is the result of demand shrinkage. Selgin also goes on to allude to Hayek’s view that that stability of spending should be the objective of monetary policy rather than the stability of prices – akin to what Market Monetarists dub the stability of monetary velocity.

Japan’s monetary base has expanded by 170% since March 2013 but at the same time the money multiplier – Money Stock/BoJ Monetary Base – has declined from 8.27 times (April 2013) to 3.35 times (March 2016). Lending market growth was at its weakest for three years in March (+2%) principally due to household hoarding.

Bloomberg - Japan Money Mult and Money base

Source: Bloomberg, BoJ

Since the announcement of Negative Interest Rate Policy (NIRP) in January the sale of safes for domestic residences has increased dramatically. Whilst I have not found evidence from Japan, this article from Bloomberg – Cash in Vaults Tested by Munich Re Amid ECB’s Negative Rates reports that MunichRE – the world’s second largest reinsurer – is setting a worrying precedent, it’s one thing when individuals hoard paper money but, when financial institutions follow suit, monetary velocity is liable to plummet. I suspect institutions in Switzerland and Japan are also assessing the merits of stuffing their proverbial mattresses with fiat money.

The chart below reveals that declining monetary velocity is not exclusively a Japanese phenomenon:-

Monetary Velocity - CLSA

Source: CLSA, CEIC

The Yotai Gap – the difference between bank deposits and loans – is another measure of household hoarding. It widened to JPY 207.6trln in March, close to its record high of JPY 209.9trln in May 2015. The unintended consequences of NIRP is an increase in demand for paper money and a reduction of demand for retail loans even as interest rates decline.

Japanese industry looks little better than the household sector, as this excellent article from Alhambra Investment Partners – It’s Not Stupidity, It Is Apathy (For Now) explains:-

Japanese industry has not gained anything for the surrender of Japanese households, with industrial production falling 3.5% in April, the 18th time in the past the 22 months. IP in April 2016 was slightly less than the production level in April 2013 when QQE began. Worse, IP is still 3.4% below April 2012, which further suggests both continued economic decline and a distinct lack of any effect from all the “stimulus.”

Barron’s – Unintended Consequences of NIRP listed the following additional effects:-

1) compress net interest margins and bank profits;
2) damage consumer and business confidence;
3) provide little incentive for business invest in capital rather than buy back stock;
4) hurt savers;
5) makes active management more difficult by dampening dispersion;
6) increase demand for gold and other hard assets; and,
7) likely widen the wealth gap

The BoJ can continue to buy JGBs, Commercial Paper, Corporate Bonds, ETFs and, once these avenues have been exhausted, move on to the purchase of common stocks and commercial loans. It can nationalise the stock market and circumvent the banking system in order to provide liquidity to end users or even consumers. At what point will the markets realise that they have been pushing on a string for decades? I suspect, not yet, but a dénouement, an epiphany, draws near.

Markets since the announcement of NIRP

Since the BoJ NIRP announcement at the end of January, the JPY has strengthened by around 14%. The five year chart below shows the degree to which the hopes for the first arrow of Abenomics have been dashed:-

japan-currency 5yr

Source: Trading Economics

Currency weakness has put pressure on stocks. International investors sold around JPY 5trln during in a 13 week selling binge to the beginning of April:-

japan-stock-market 5yr

Source: Trading Economics

The Government Pension Investment Fund (GPIF) and other domestic institutions took up the slack – the GPIF has moved from 12% to 23% equities since October 2014 – here is the 31st December breakdown of the asset mix for the JPY 140trln fund:-

31-12-15 % Allocation Policy Target Permitted Deviation
Domestic Bonds 37.76 35 10
Domestic Equity 23.35 25 9
International Bonds 13.5 15 4
International Equities 22.82 25 8
Short term assets 2.57

Source: GPIF

In theory the GPIF could buy another JPY 15.5trln of domestic stocks and reduce its holdings of JGBs by nearly JPY 18trln. I expect other Japanese pension funds and Trust Banks to follow the lead of the GPIF. Domestic demand for stocks is likely to continue.

As I mentioned earlier, JGBs are being steadily accumulated by the BoJ even as the GPIF and other institutions switch to equities. This is the five year yield chart for the 10 year maturity:-

japan-government-bond-yield 5yr

Source: Trading Economics

JGBs made new all-time lows earlier this month, with maturities out as far as 15 years turning negative, amid international concerns about the potential impact of Brexit.

Looking more closely at Japanese stocks, non-financial corporations have followed the lead of the eponymous Mrs Watanabe, accumulating an historically high cash pile. Barron’s – Abenomics Watch: Japan’s Corporates Are Hoarding Cash, Too takes up the story:-

During the three years of Abenomics between 2013 and 2015, Japan’s non-financial corporate sector increased its holding of cash and deposits by roughly 30 trillion yen, or 6% of GDP. This amount is equivalent to about 35% of retained earnings, estimates Credit Suisse.

This amount is high by historical standards. During the previous economic upswing between the end of 2002 and the beginning of 2008, Japan’s corporations held only 11.5% of their retained earnings.

So why are Japanese companies hoarding cash?

One explanation is larger intangible assets. It is easy for companies to put up their fixed assets as collateral for loans, but how should banks value intangible assets such as intellectual property? Cash would be a viable collateral option. However, Credit Suisse finds that there is not much correlation between cash and intangible asset positions. The ratio of cash to intangible fixed assets investments has moved broadly between 8.6 years and 11.6 years over the two decades since 1994.

A second explanation is lax corporate governance, which Abe has been trying to fix. Are Japanese companies only paying him lip service?

A third explanation is increasing pension liabilities. As Japanese society ages, companies feel compelled to hoard more cash to pay off employees who are due to retire in the coming years. Encouraging women to enter the labor force is a key component of Abenomics’ Third Arrow. He has not gone very far.

Last, perhaps Japanese companies are feeling uncertain about the future? Toyota Motor, for instance, drastically changed its yen assumption from 120 to 105 in the new fiscal year. Companies hoard more cash when they don’t know what’s going to happen.

According to the latest flow of funds data from the BoJ – corporate cash was estimated to be JPY 246trln in Q1 2016 – the 29th consecutive quarterly increase, whilst household assets rose to JPY 902trln the highest on record and the 36th quarterly increase in a row. A nine year trend.

Another trend which has been evident in Japan – and elsewhere – is an increase in share buybacks. The chart below tells the story since 2012:-

Topix Share buy backs

Source: FT, Goldman Sachs

Compared to the level of share buy backs seen in the US, Japanese activity is minimal, nonetheless the trend is growing and NIRP must assume some responsibility. Perhaps it was the precipitous decline in capital expenditure, which prompted the BoJ to introduce NIRP. The chart below is taken from the December 2015 Tankan report:-

japan-tankan-capex-index-q1-2016

Source: Business Insider Australia, BoJ

In the March 2016 Tankan, the Business Conditions Diffusion Index remained generally positive but the decline of momentum is of concern:-

Dec-15 Mar-16 June-16(F/C)
Large
Manufacturers 12 6 3
Non-Manufacturers 25 22 17
 
Medium
Manufacturers 5 5 -2
Non-Manufacturers 19 17 9

 Source; BoJ

I doubt capital expenditure will rebound while share buy backs appear safer to the executive officers of these companies. The Japanese stock market is also attractive by several valuation metrics. The table below compares the seven most liquid stock markets, as at 31st March, is sorted by the yield premium to 10 year government bonds (DY-10y):-

Country CAPE PE PC PB PS DY 10y DY-10y
Switzerland 20.3 22.5 13.9 2.3 1.8 3.50% -0.33% 3.83%
France 16 20.9 6.5 1.5 0.8 3.50% 0.41% 3.09%
Germany 16.8 19 8 1.6 0.7 2.90% 0.15% 2.75%
United Kingdom 12.7 35.4 12.8 1.8 1.1 4.00% 1.42% 2.58%
Italy 11.1 31.5 5 1.1 0.5 3.50% 1.23% 2.27%
Japan 22.7 15.3 7.9 1.1 0.7 2.20% -0.04% 2.24%
United States 24.6 19.9 11.6 2.8 1.8 2.10% 1.77% 0.33%

Source: StarCapital.de, Investing.com

For international allocators, the strength of the JPY has been a significant cushion this year, but, for the domestic investor, the Nikkei 225 is down 16.2% YTD. Technically the market is consolidating around the support region between 16,300 and 13,900. If it breaks lower we may see a return towards to 10,000 – 11,000 area. If it recovers, a push through 18,000 should see the market retest its highs. I believe the downside is supported by domestic demand for stocks as bond yields turn increasingly negative.

International investors will remain wary of the risks associated with the currency. Further BoJ largesse must be anticipated; that they have made a first provision against losses from the unwinding of QQE is but a warning shot across the bows of the ministry of finance. As I suggested in Macro Letter – No 49 – 12-02-2016 Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous? a currency hedged equity investment is worth considering. Prime Minister Abe, who began campaigning, this week, for the upper house elections on July 10th, has promised to boost the economy if he wins a majority of the 121 seats being contested. The monetary experiment looks set to continue but the BoJ may be the first central bank to discover the limits of largesse.

 

Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous?

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Macro Letter – No 49 – 12-02-2016

Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous?

  • The Bank of Japan announcement of NIRP sent shock waves through currency markets
  • The Yen has strengthened on capital repatriation since the BoJ move
  • JGB 10 year yields turned negative this week
  • Longer-term the Yen will weaken

At the end of January the Bank of Japan (BoJ) shocked the financial markets by announcing that they would allow Japanese interest rates to become negative for the first time. USDJYP reacted with an abrupt rise from 118 to 121 which was completely reversed a global stock markets declined USDJYP is currently at 112.06 (11-02-2016). The three year chart below shows the extent of the move:-

USDJPY_-_3yr

Source: Big Charts

Here is an extract from the BOJ Announcement:-

The Introduction of “Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate” 

The Bank will apply a negative interest rate of minus 0.1 percent to current accounts that financial institutions hold at the Bank. It will cut the interest rate further into negative territory if judged as necessary.

The Bank will introduce a multiple-tier system which some central banks in Europe (e.g. the Swiss National Bank) have put in place. Specifically, it will adopt a three-tier system in which the outstanding balance of each financial institution’s current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate, or a negative interest rate will be applied, respectively.

“QQE with a Negative Interest Rate” is designed to enable the Bank to pursue additional monetary easing in terms of three dimensions, combining a negative interest rate with quantity and quality.

The Bank will lower the short end of the yield curve and will exert further downward pressure on interest rates across the entire yield curve through a combination of a negative interest rate and large-scale purchases of JGBs.

The Bank will achieve the price stability target of 2 percent at the earliest possible time by making full use of possible measures in terms of the three dimensions.

In answer to the title question, part of the surprise was due to BoJ Governor Kuroda-san’s volte face. Prior to his departure for Davos, he had ruled out the adoption of negative interest rate policy (NIRP) upon his return the BoJ announced the NIRP “out of the blue”.

I was also surprised, not that the BoJ had adopted NIRP, but that it had taken so long for them to “fall on their sword”. After all, they have been struggling with deflation and low bond yields for more than a decade and embarked on QQE ahead of their collaborators at the ECB, SNB, Riksbank and Danmarks Bank. The Economist – Negative Creep – makes some important observations:-

Almost a quarter of the world’s GDP now comes from countries with negative rates.

Not so long ago it was widely thought that, if interest rates went below zero, banks and their depositors would simply switch to cash, which pays no interest but doesn’t charge any either. Yet deposits in Europe, where rates have been negative for well over a year, have been stable. For commercial banks, a small interest charge on electronic deposits has proved to be bearable compared with the costs of safely storing stacks of cash—and not yet onerous enough to try to pass on to individual depositors.

That has resulted in an unavoidable squeeze on profits of banks, particularly in the euro area, where an interest rate of -0.3% applies to almost all commercial-bank reserves. (As in Switzerland and Denmark, Japan’s central bank has shielded banks from the full effect by setting up a system of tiered interest rates, in which the negative rate applies only to new reserves.) If interest rates go deeper into negative territory, profit margins will be squeezed harder—even in places where central banks have tried to protect banks. And if banks are not profitable, they are less able to add to the capital buffers that let them operate safely.

Perhaps the answer lies in the transient influence NIRP had on the value of the JPY. The Yen had risen quite sharply amid repatriation of risk assets during the first weeks of January, the BoJ announcement stemmed the tide briefly, until the flood resumed. The move beyond Qualitative easing – which provides “permanent” capital but does not make its presence felt to the same extent – should have caused the Yen to recommence its secular decline. With the liquidation of asset flows dominating the foreign exchanges the BoJ’s action was like a straw in the wind. Negative rates may be instantly recognizable whilst the purchase of common stock is masked by the daily ebb and flow of the stock market, but when investors are exiting “pursued by Bear” central bankers need to act with greater resolution – in time I expect the BoJ will adopt a more negative stance.

In the longer run NIRP will reduce the attractiveness of the Yen, which brings me to a second question – is NIRP is more or less damaging, to the economy, than the QQE which has gone before? I am assuming here, that QQE, like all the forms of quantitative easing to emanate from the coffers of the major central banks, is inherently damaging to the economy because these policies artificially lower the rate of interest, leading to malinvestment. This destroys long run demand by reducing the return on savings – especially important in a country where the population is rapidly aging. More pensioners with less income from their savings, more workers with inadequate pension provisions due to low interest rates and more defined benefit pension funds at risk of default due to insufficient funding of their liabilities. An added twist to this sorry situation is the propensity for unprofitable businesses to continue to operate, inexorably dragging down productivity. These are just a few of the unintended consequences of engineering interest rates below their natural level.

Investment Opportunities

In the past I have been bullish for the Nikkei on a currency hedged basis. The five year chart below shows the relative performance versus the Eurostoxx 50 over the last five years:-

Nikkei 225 vs Eurostoxx 50 - 5yr

Source: Yahoo Finance

Long Nikkei 225 hedged may still prove a positive strategy, although the up-trend appears to have failed in the near term, but I believe, in the long run, under the BoJ – “QQE with NIRP” regime, the best trade will be to short the Yen. Again, the near term the trend is unfavourable – repatriating capital flows may be the driving force – when the capital flows subside, the “Emperor” will be seen to have “less than zero” clothes. The Yen should run into resistance around 110 and again at 105 – keep your powder dry.

10yr JGBs yields nudged into negative territory this week, whilst the 40yr maturity has backed up from 1.12% to 1.23% over the past seven sessions. That may not seem much of a return, but longer dated maturities are likely to offer increasingly attractive carry potential as market participants attempt to establish the “limit of NIRP”. JGB futures offer a reasonably clean way of participating in any upside whilst hedging the majority of your currency exposure in either direction. You may be late to the trade, however, as the eight year, monthly yield chart below reveals:-

japan-government-bond-yield 2008-2016 Monthly

Source: Trading Economics

The US$ as a store of value

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Macro Letter – No 20 – 26-09-2014

The US$ as a store of value

  • The US$ Index has broken above July 2013 highs as the US economy strengthens
  • The Trade Weighted Index also reflects this trend
  • But the Trade Balance remains in deficit

US$ Index - 25yr - Barchart.com

 

Source: Barchart.com

As the US economic recovery continues to gather momentum, what are the prospects for the US$ versus its principal trading partners? This is key to determining how swiftly and to what degree the Federal Reserve will tighten monetary conditions. Above is a 25 year monthly chart of the US$ Index and for comparison, below is the US$ Trade Weighted Index (TWI) as calculated by the Philadelphia Federal Reserve. The TWI shows the initial flight to quality during the onset of the Great Recession, the subsequent collapse as the Fed embarked on its increasingly aggressive programme of QE, followed by a more orderly recovery as the US economy began its long, slow rebound. It is still only a modest recovery and I would not be surprised to see a slow grind higher towards the initial post crisis highs around 113 – this is only a 50% retracement of the 2001-2011 range. In the longer term a return to the “strong dollar” policies of the late 1990’s might be conceivable if the current industrial renaissance of the US continues to gather momentum:-

US$ TWI - 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

During the late 1990’s the US$ soared on a combination of strong economic growth, a technology asset bubble and relatively benign inflation due to the disinflationary forces of globalisation, emanating especially from China. During the current decade another technology revolution has been underway as the US becomes self-sufficient in energy production. I am not referring simply to “fracking” as this paper from the Manhattan Institute – New Technology for Old Fuel – April 2013 explains: –

Between 1949 and 2010, thanks to improved technology, oil and gas drillers reduced the number of dry holes drilled from 34 percent to 11 percent.

Global spending on oil and gas exploration dwarfs what is spent on “clean” energy. In 2012 alone, drilling expenditures were about $1.2 trillion, nearly 4.5 times the amount spent on alternative energy projects.

Despite more than a century of claims that the world is running out of oil and gas, estimates of available resources continue rising because of innovation. In 2009, the International Energy Agency more than doubled its prior-year estimate of global gas resources, to some 30,000 trillion cubic feet—enough gas to last for nearly three centuries at current rates of consumption.

In 1980, the world had about 683 billion barrels of proved reserves. Between 1980 and 2011, residents of the planet consumed about 800 billion barrels of oil. Yet in 2011, global proved oil reserves stood at 1.6 trillion barrels, an increase of 130 percent over the level recorded in 1980.

The dramatic increase in oil and gas resources is the result of a century of improvements to older technologies such as drill rigs and drill bits, along with better seismic tools, advances in materials science, better robots, more capable submarines, and, of course, cheaper computing power.

 The productivity gains are substantial within the Oil and Gas industry but the benefits are just beginning to percolate out to the broader economy.

Here is US GDP over the last twenty years: –

US GDP - 1995-2014 - Trading Economics

Source: Trading Economics

Growth since the Great Recession has been relatively anaemic. To understand some of the other influences on the US$ we also need to consider the US Trade Balance: –

US Trade Balance - 1995-2014 - Trading Economics

Source: Trading Economics

The USA continues to be the “consumer of last resort”. Here, by contrast are the EU GDP (1995-2014) and Trade Balance (1999-2014): –

EU GDP 1995-2014 - Trading Economics

Source: Trading Economics

EU Trade Balance - 1999-2014 - Trading Economics

Source: Trading Economics

Europe is also a major export market for Chinese goods but nonetheless appears to rely on trade surpluses to generate sustainable growth. Since the Great Recession the EU has struggled to achieve any lasting GDP growth despite a significant increase in its trade surplus. This is because a large part of the terms of trade improvement has been achieved by reducing imports rather than increasing exports, especially in the Euro Zone (EZ) peripheral countries. The austerity imposed on EZ members by the ECB has encouraged some external trade but the prospect for any sustained recovery in EZ growth is limited.

China has, of course, been a major beneficiary of the US trade deficit, although, since the Great Recession, trade surplus data has become significantly more volatile: –

China Trade balance - 1995-2014 - Trading Economics

Source: Trading Economics

The chart above doesn’t really articulate the colossal increase in Chinese exports – between 2004 and 2009 China’s trade surplus increased ten-fold. Despite the more recent policy of “Rebalancing” towards domestic consumption, the latest data takes this surplus to a new record.

The US response to the trade deficit

The US government is concerned about the structural nature of their trade deficit but this is balanced by capital account surpluses as this report from the Congressional Research Service – Financing the U.S. Trade Deficit – March 2014 explains: –

According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses.

The chart below shows the continued increase in foreign holdings of US assets between 1994 and 2012: –

Foreign_Official_and_Private_Investment_Positions_

Source: US Commerce Department

The Congressional Research Service concludes:-

The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long term rate of growth for the economy. In particular, some observers are concerned that foreigner investors’ portfolios will become saturated with dollar denominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded.

Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital.

Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar’s international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness

In addition, the nation’s net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case.

The author appears to be saying that, so long as foreign private investors are prepared to continue acquiring US assets, the US need not be overly concerned about the deficit. Given that this should be negative for the US, what are the medium-term implications for the US$?

Gold vs US$

Evaluating the US$, in a world where all the major fiat currencies are attempting to competitively devalue, is fraught with difficulty, however, the price of gold gives some indication of market perceptions. It seems to indicate a resurgence of faith in the US currency:-

Gold - 25 year - Barchart

Source: Barchart.com

The substantial appreciation in the price of gold since 2001 is evident in the chart above, however, since the US economy began to recover from the Great Recession and financial markets perceived that QE3 might suffice to avert deflation, gold has lost some of its “safe-haven” shine. 10 yr US Treasuries yield 2.56%, the S&P 500 dividend yield is 1.87% – whilst these are historically low they look attractive compared to 10 yr German Bunds at 0.97% or 10 yr JGBs at 0.54%.

Leading Indicators

The Philadelphia Federal Reserve – Leading Indicators shows the breadth and depth of the prospects for the US economy, below is their latest heat map: –

Philly_Fed_-_July_2014_Leading_Indicators

Source: Philadelphia Federal Reserve

Below is a chart of the evolution of US Leading Indicators since 1995: –

US Leading Indicators 1995-2014 - St Louis Fed

Source: St Louis Federal Reserve

The relative strength of the Leading Indicators has not been as evident in the GDP data. This supports arguments such as CEPR – Is US economic growth over? September 2012 by Robert Gordon in which he promulgates his theory of structurally lower productivity growth in the US over the coming decades.

Personally I am not convinced that we have seen the end of productivity growth. I believe the extraordinary improvements in energy technology and productivity will begin to show up in broader data over the next few years.

Which leads me back to pondering on Governor Yellen’s recent comments after the FOMC Press Conference:-

…If we were only to shrink our balance sheet by ceasing reinvestments, it would probably take, to get back to levels of reserve balances that we had before the crisis. I’m not sure we will go that low but we’ve said that we will try to shrink our balance sheet to the lowest levels consistent with the efficient and effective implementation of policy. It could take to the end of the decade to achieve those levels.

This suggests the Federal Reserve may never sell any of the assets they have purchased but simply hold them to maturity. In an oblique way this view is supported by a paper from the Chicago Federal Reserve – Measuring fiscal impetus: The Great Recession in historical context which was published this week. They examine the link between changes in fiscal policy in the immediate wake of the Great Recession and more recently the slow pace of this cyclical recovery. Looking forward they opine: –

Fiscal policy during the Great Recession was more expansionary than in the average post-1960 recession, with declines in taxes, increased in transfers, and higher purchases all contributing to higher than typical fiscalimpetus. This pattern reversed itself following the cyclical trough, with declining purchases, particularly among subnational governments, accounting for most of the shortfall. By mid-2012, cumulative fiscal impetus was below the average level in other post-1960 recessions. Although fiscal restraint is expected to ease somewhat over the coming years, there is no indication that fiscal policy will be a meaningful source of economic growth in the near future.

If fiscal policy is unlikely to be a meaningful source of economic stimulus in the near future then monetary policy will have to do the lion’s share of the heavy lifting.

Where next for the US$

The economic fundamentals of the US economy look solid. Regions like Texas might even be in danger of overheating as this report from the Dallas Federal Reserve – Regional Growth: Full Steam Ahead – makes clear:-

The regional economy is surging, with the Texas Business Outlook Survey (TBOS) production and revenue indexes at multiyear highs and annualized job growth of 3.6 percent year to date. Second-quarter job growth was 4.6 percent annualized, and July job growth was just as fast. Energy production continues to increase, and the rig count has risen since last August in spite of a decline in oil prices. Texas exports rebounded in July.

… All told, the regional economy is growing at an unsustainable pace. Texas employment has grown at more than twice its long-run average rate over the past four months. Declines in unemployment measures have slowed, suggesting Texas is near full employment and slack is being depleted. The rapid growth has led to labor shortages, which can cause bottlenecks in production and hurt productivity. Tight labor and housing markets are leading to mounting wage pressures and increasing prices.

Dallas Federal Reserve President Richard Fisher has been a hawk for as long as I can remember, however, he plans to retire in April of next year. As does his fellow hawk Charles Plosser – President of the Philadelphia Fed, although Jeffrey Lacker – President of the Richmond Fed – will take up the hawkish cause in 2015. Nonetheless this weakens to case for any rapid tightening of policy beyond the tapering of QE.

Given the zero bound interest rate policies of all the major central banks, growth rather than expectations of widening interest rate differentials is more likely to determine the direction of currencies. Therefore, the slower the Federal Reserve act in tightening policy, the stronger the momentum of US GDP growth, the larger the capital inflows and the stronger the support for the US$.

Elsewhere, the prospects for EU growth are much weaker. Further QE is imminent after last week’s disappointing uptake of TLTRO funds – Bruegal – T.L.T.R.O. is Too Low To Resuscitate Optimism has more detail. The BoJ, meanwhile, continues with its policy of QQE yet, without the Third Arrow of the Abenomics – serious structural reform – Japan is unlikely to become an engine of economic growth. China continues its rebalancing but the momentum of growth is downward. In this environment the US looks like a land of opportunity to the optimist and the “least worst” safe-haven in an uncertain world for the pessimist. Either way, barring a substantial escalation in direct geopolitical risk, the US$ is unlikely to weaken. Technically the currency is looks set to appreciate further; in so doing this may create a virtuous circle reducing import price inflation and delaying – or possibly mitigating the need for – tightening by the Federal Reserve.