In December 1999 Ben Bernanke delivered a paper titled Japanese Monetary Policy: A Case of Self-Induced Paralysis?
whereby he criticized the Bank of Japan for not doing enough to stem the deflation that had plagued Japan throughout the 1990s. In the section titled How to Get Out of a Liquidity Trap,
Bernanke goes through his playbook for how to stimulate aggregate demand once interest rates have hit the zero bound. His remedies are all too familiar to us now and include an inflation target, depreciating the currency, the so-called helicopter drop of money and “non-standard” asset purchases:
In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.
…the BOJ should attempt to achieve substantial depreciation of the yen, ideally through large open-market sales of yen. Through its effects on import-price inflation (which has been sharply negative in recent years), on the demand for Japanese goods, and on expectations, a significant yen depreciation would go a long way toward jump-starting the reflationary process in Japan.
An alternative strategy, which does not rely at all on trade diversion, is money-financed transfers to domestic households—-the real-life equivalent of that hoary thought experiment, the “helicopter drop” of newly printed money.
A nonstandard open-market operation without a fiscal component, in contrast, is the purchase of some asset by the central bank (long-term government bonds, for example) at fair market value. The object of such purchases would be to raise asset prices, which in turn would stimulate spending (for example, by raising collateral values).
In the section discussing depreciating the yen Bernanke noted the yen has undergone a nominal appreciation since 1991, a strange outcome for a country in deep recession
and that more recently hit had appreciated from 145 yen/dollar to 102. The appreciation between 1998 and 1999 of course was on the heels of the Asian currency crisis that was a response to the weakening yen. Over this time frame the yen rallied 30% against the US dollar. Over the following decade the yen would go on to appreciate another 25% against the US dollar, namely as the Federal Reserve operated a prolonged easy money monetary regime at the expense of continued deflationary pressures in Japan.
Late last year a series of events unfolded that point to a potential paradigm shift in this relationship between US and Japanese monetary policy and the currency value. In September former Japanese Prime Minister Shinzo Abe was elected to head the opposition Liberal Democratic Party (LDP). Abe had been an outspoken monetary dove running on an agenda to end Japanese deflationary economic woes. In November, then current Prime Minister Yoshihiko Noda dissolved Parliament paving the way for new elections in December for which the LDP won with Abe being elected Prime Minister a few days later.
had been pretty clear on his intentions to get the Bank of Japan to raise its inflation target and with his election to power, the markets have responded accordingly . You can see on the chart below that on November 14, when Noda dissolved Parliament, the markets got the message that a policy shift was forthcoming and this has led to a yen reflation correlation in the Japanese stock market that has had a clear impact on US stocks and bonds.
Yen Reflation Trade:
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On Wednesday, November 14, USDJPY opened at 79.50, and this past Wednesday, when the Bank of Japan Governor announced he was stepping down before his term ended, USDJPY made a new cycle high at 94.05 for a gain of 18%. Over the same time frame the Nikkei
(INDEXNIKKEI:NI225) has rallied by 32% for an astounding annualized gain of 245%. Here in the US the S&P 500
(INDEXSP:.INX) has followed the yen reflation trade rallying 13% since November 16 with the US 30-year bond futures topping on the same day, leading to a 50bps back up in the long end of the curve.
I have been monitoring the developments in Japan for over a month now and was initially skeptical that the move in US stocks and bonds was signaling some breakout in growth expectations. On January 7 in Is US Growth Blowing Out or the QE Carry Trade Blowing Up?
I raised the flag:
The interpretation of last week’s market movement was that because bond prices were falling and stock prices were rising, money was flowing out of bonds and into stocks, or that the trade was risk-on due to anticipation of accelerating US economic growth. As bond yields were breaking out of their range with stocks closing at a new high the larger conclusion was that this potentially signaled a seminal change in investment flows, or as some suggested, the much-anticipated great rotation out of bonds and into stocks was underway. I don’t think it’s quite that simple.
The correlation between the USDJPY and US interest rates can be seen as a proxy for the larger QE short US dollar asset correlation trade. It’s quite possible that bond yields and the dollar aren’t rising due to an acceleration of growth but rather because the Bank of Japan is blowing up the Fed’s QE carry trade.
The irony is thick, isn’t it? A decade later Japan is finally capitulating on deflation by taking Bernanke’s advice to raise the inflation target and devalue the yen, but its interfering with Bernanke’s own QE policy to lower US interest rates. The funny part is that Federal Reserve officials don’t even appear understand what is going on. It’s as if they are drinking the Kool-Aid passed out by Wall Street pundits and media, thinking QE is finally taking hold and the Great Rotation is underway.
Just last week, perhaps the biggest dove on the FOMC, Chicago President Charles Evans, said the following in an interview with CNBC’s Steve Liesman
And moving down to 7%. I tend to think it might be possible to turn off the quantitative easing. We get off to a fast start on the run, we build momentum and then we're just going to keep going. It’s self-sustaining. We wouldn't have to continue to carb up along the run and so that's why we might be able to stop before 7%. But I’m open-minded, and I think that these policies have done a lot of good, auto sales are up. Housing is turning the corner. I think our policies are improving things.
This is the guy for whom the current open-ended policy targeting the unemployment rate is named. As a reminder they just initiated this program at the December meeting. I think the Fed itself is getting sucked into the stock market euphoria, which is no more than a correlation trade. Fed Governor Jeremy Stein
said last week that he was concerned investors were reaching for yield in corporate credit:
Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.
Where have we heard that before? Anyway, I thought that’s what they wanted us to do. The whole QE policy is supposed to be a yield grab.
The last currency correlation trade ended in disaster. When the Fed disappointed investors by failing to extend QE II in July of 2011, the short US dollar asset reflation correlation came unwound in spectacular fashion with the S&P 500 melting 17% in a two-week period. I am starting to see some cracks in this trade, and with the Bank of Japan scheduled to meet this week with a decision scheduled for Valentine’s Day, I think investors need to be aware of the implications of their actions.
Yen Beta Trade:
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As I mentioned before the USDJPY topped last Wednesday when the BOJ Governor announced his departure. Was this a selling of the news so to speak? You can see on the chart above that the high beta EURJPY is starting to see some deterioration in relative strength as US stocks made new highs on Friday. This is what technicians refer to as negative divergence. On a weekly basis the EURJPY was recently as overbought as it has been in 10 years, suggesting there is little room for upside without some serious consolidation of these historic gains.
In JY futures at the CME
, which trade inverse to USDJPY, large speculators have built up a significant short position that is the largest since 2007. You can understand that if the BOJ disappoints investors on Thursday the conditions are in place for a big short squeeze as these traders could be operating with itchy trigger fingers. This was evident on Friday when Japanese Finance Minister Taro Aso said the pace of the yen’s slide was too fast as reported by Bloomberg
Japanese Finance Minister Taro Aso
said the pace of the yen’s weakening has been too fast, speaking a week before a meeting of global finance chiefs
where Japan’s currency stance is forecast to be an issue.
Aso’s comment to reporters in Tokyo today came after he earlier told lawmakers the government hadn’t anticipated a rapid move to around 90 per dollar
. The yen slumped 13% since mid-November in anticipation of monetary stimulus advocated by Shinzo Abe
, who took office as prime minister in December. It rose as much as 1.6% today, the most since March 2011
The other side of the yen correlation trade in US Treasuries is also showing signs that momentum is slowing. In December when I cited the 143-00 level in US bond futures as a target for a big bull/bear battle in 2013, I had no idea it would come so soon, but I did realize the significance of the outcome. In A 2013 Bond Market Prognostication
, I wrote the following:
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it’s very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don’t expect it to go quietly; it will likely put up a tough fight.
US Bond Futures 10-Day Tick:
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Then on January 28 in The Great Rotation? The Market Is a Bit More Complicated Than That
, I tightened up the analysis:
You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.
As you can see on the 10-day tick chart during the following two weeks the US bond futures is clearly “vibrating” 143-00 and has repeatedly tested this level only to turn higher. If the BOJ can’t take out 143-00 next week the bond market could be setting up for a big rally as it appears all the yen reflation trade selling has been absorbed.
The Japanese yen has seen some massive depreciation in a relatively short period of time. This movement has led to a risk rally in both Japan the US, but thus far it’s been all talk. The BOJ has raised the inflation target to 2%, but will this in and of itself actually generate inflation, or will it need to continue to take Bernanke’s advice and devalue the yen? We are still in the early innings so its still early to tell. However the market has clearly built up big expectations with some big bets being placed which, in my experience, sets up for a big accident and perhaps even a massacre.