The first act by the new head of the Bank of Japan, Haruhiko Kuroda, was an unprecedented expansion of the country’s quantitative easing (QE) program which is designed to double the BoJ’s balance sheet over the next seven quarters. In attempting to create a CPI running at 2%, the BoJ has set in motion a potential nightmare for itself with the unintended consequence of strengthening the euro and touching off a run on the Japanese yen that is far beyond anything currently anticipated.
One of the real problems with central bank money printing is the inability of the central bank to direct where the money goes. The efforts of the FOMC under Mr. Ben Bernanke’s direction have resulted in a perfect market from the US' perspective – falling commodity prices, rising US equities, high US bond prices, and weak gold. It almost makes one believe that central planning could work, except for the ever deteriorating employment situation and weak commercial credit growth.
Moreover, to engineer this near miracle the Fed has had to have a willing accomplice in the Bank of Japan and the new Japanese government. Without actually engaging in anything more than harsh language the Abe government was able to engineer a move in the yen from ¥78 to ¥93. This selling of the yen created artificial demand for US dollars, which helped keep a lid on gold prices while mitigating any effect of a rallying euro on the trade-weighted dollar index, the USDX.
Now, however, that the BoJ has unveiled its plan to reflate the Japanese economy, we are looking at a completely different situation. Japan has been able to run up the kind of debt-to-GDP ratio it has because of the forbearance of Japanese investors willing to accept miniscule yields in a slightly deflationary environment. But, now that those same pension funds and institutional investors are looking at a government and central bank determined to get inflation at 2% at literally any cost, the game has changed and they will have to start seeking yield elsewhere.
That elsewhere is and will be high-yield sovereign debt, and the first wave will flow into the eurozone because of the implicit stability of the region via ECB president Mario Draghi’s restating last week that the euro is eternal. And because of this the money from Japan will flow preferentially into the highest yield and highest rated debt – Italy, Spain, and Belgium on the table below. I picked 7-year bond yields to illustrate this point to ensure a maturity that was not being actively manipulated by the Federal Reserve which has destroyed the less than 3-year and greater than 10-year market.
Japanese 7-year bonds yields have risen sharply along with German bunds, likely because of a spillover effect of investors dumping very low yield. Given the current yield on the US 7-year bond I would say that that rally is nearly over as well. This effect is not just seen in higher yielding highly rated bonds either. Malaysia’s 5-year bond yields have dropped to 3.19%, a 5-month low, from 3.23% on April 1.
The takeaway here is that this will have a long-term bullish effect on the euro, regardless of what one may think of the fundamentals. A weekly close this week above $1.305 on the euro would create a reversal signal that the current weakness in the euro is over. Euro Brent crude prices are currently at 2-year lows, below €81 per barrel.
A strong euro mixed with relatively weak commodity -- especially energy -- prices and capital flowing out of Japan will be structurally very constructive for a number of the weak euro countries who will then import the raw materials needed to rebuild sagging domestic economies while massively raising energy costs in an economy that is shrinking.
So, the Bank of Japan’s attempt to create domestic growth will do nothing more than cause massive capital flight out of Japan and the yen, likely causing a repudiation of the yen completely. This policy will come back to hit the Japanese leaders squarely in the face.
No positions in stocks mentioned.