Notes From Underground: An Open Letter To the G-7

Every G-7 or G-20 meeting homage is paid to the idea of free markets via the market driven value of each nation’s currency. This is hogwash of the highest order in the world of central bank asset purchase programs. The clarion call is that QE is a domestic-based program meant to meet the inflation target set by the nation’s policy makers and any impact on a nation’s currency is just unintended consequences of keeping a country out of a potential disinflationary cycle. Every central bank statement except the U.S. has a sentence or two about the relative value of a nation’s currency and if too strong then concern about a strong currency being a headwind in meeting the illusion and capriciousness of that 2% inflation target.


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Case in point: On Monday night, the Reserve Bank of Australia released its latest interest rate decision. As I rightly assumed, there was one sentence of the current Aussie dollar rate and its relative value to the major currencies and its key trading partners. (“The Australian dollar remains in the upper end of the range of recent years.”) Ahead of the meeting the currency has been steady this year versus the euro and the dollar, 1% lower versus the KIWI, 4% lower against the Canadian dollar, weaker versus China and 7% stronger against the YEN.

Overall, the Aussie dollar is a non-event but concern for it on a trade-weighted basis will keep the RBA holding interest rates at 0.10% while exerting yield curve contol on the rates out to three years by actively buying three-year Aussie bonds. Regardless of the RBA, we at NOTES FROM UNDERGROUND are most concerned about the WEAKNESS of the Japanese yen against the majority of the world’s more important currencies. Is the YEN weakness in a WEAK DOLLAR environment a result of rising inflation in Japan (and thus negative real yields)? No, as Japan most probably has the best record on inflation while rising inflation in Germany is leaving German bond holders with increasing NEGATIVE REAL YIELDS.

The U.S. has much worse NEGATIVE real yields. The list goes on. Why is it that the YEN remains the weakest of the world’s developed currencies? The riddle is solved by analyzing the BOJ’s balance sheet. In the Mainichi, a Japan National Daily, there was an article on Friday titled, “Bank of Japan Assets Quadruple to $6.5 trillion Under Kuroda’s Aggressive Easing.” The story details that in an effort to reach its “mystical 2% inflation target,” it increased its bond holdings by 9.5% to 532.17 trillion yen and boosted its ETF purchases by 20.7% over the past year to 35.88 trillion yen. (Note, the ETFs have a market value of 51.51 trillion yen leaving the BOJ with a sizable profit up to this point.)

The BOJ’s activity is not alchemy like the Swiss National Bank, which directly purchases foreign equities and bonds with freshly printed Swiss francs in an effort to keep its currency  from dramatically appreciating. The Japanese manipulation of its currency is more insidious. The Japanese savers, insurance companies and pension funds are the world’s largest creditors/investors. As the BOJ increases its BALANCE SHEET, Japanese investors are forced to look outside the country for investment opportunities as there are few BONDS to buy and the idea of racing the BOJ to acquire Japanese assets at a reasonable price is a fool’s errand.

This leaves foreign markets as the the only alternative. The more foreign assets that Japan’s investors purchase the weaker the YEN on a relative basis. If my THESIS is correct there could be some increased volatility in all the world’s YEN crosses — eur/yen, chf/yen, cad/yen, aud/yen, and, most importantly, YUAN/YEN. (The Chinese currency has appreciated 15% versus its Japanese counterpart over the past year.)

The YUAN‘s rise is not a bad thing as it supports my view that the Chinese have been promoting a stronger currency while it increases the buying power of its middle-class consumers. The imports from Japan are not raw material-based but manufactured goods making the argument about China’s designs of YUAN strength ever more credible. But, how high is China willing to allow the YUAN/YEN cross to rise before signaling its displeasure.

In June 1998, the U.S. Treasury under Bob Rubin intervened to weaken the YEN as Bill Clinton was heading to Beijing for talks with the Chinese. (At the time, the YUAN/YEN cross was trading at 17.45 yen to the yuan.) This is something to keep in mind for it would impact several asset classes, especially foreign bonds, as Japanese investors have chased nominal yields across the globe.

***Before I forget: Over the weekend the People’s Bank of China ostensibly raised the reserve requirement for foreign assets to 7% from 5% in an effort to slow the appreciation of the YUAN. It appears to be a superficial effort and really meant to send a signal to investors to not push for too rapid a rise in the Chinese currency. Many analysts were out working their models using the increase to suggest that a 2% rise in the reserve ratio would cause banks and others to hold an extra $20 billion in reserves, which would slow the economy. HOGWASH! The Chinese economy is far too big and dynamic for such an increase to act as a drag on spending. The CHINESE economy is trying to become more consumption driven which needs a stronger currency.

Again, the policy can be found in how concerned the PBOC is about the current YUAN/YEN level as China is busy importing Japanese manufactured goods. The G-7 needs to be concerned about any trade advantage the Japanese are accruing through the policies of the BOJ and Ministry of Finance. Nominal yields almost act as an agent of fungibility in a zero interest rate world. The G-7 has been warned—now what is the potential fallout?

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