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Are We Witnessing a Tectonic Shift in Which Central Bank Policy Dominates Asset Prices and Risk Premiums?


Investors can't afford to ignore the consequences of massive moves in the foreign exchange market.

Since 2007 the Federal Reserve's easing campaign has dominated global currency markets as the value of the world's reserve currency has generally been a one-way trade. The Fed's zero interest rate policy and quantitative easing has reflated dollar-denominated commodities, and this has benefited emerging markets and their currencies. However, that all changed last September when Shinzo Abe was elected prime minister of Japan.

Abe has pledged to end Japan's persistent deflation by taking aim at the value of the yen, and the markets are responding accordingly. Since Abe was elected, the USDJPY is up 13% and EURJPY is up 20%. On Monday, the Bank of Japan met and agreed to raise its inflation target to 2%. Why does this matter to US investors?

With the exception of the aforementioned 2008 commodity spike, the last two times Japan was running 2% inflation the USDJPY was closer to 150 or 60% higher than where it is today. The most recent period of 2% inflation that coincided with yen depreciation in the mid to late 1990s caused dramatic dislocations in global markets.

Between 1995 and 1998 the USDJPY rallied from 80 to 147 which was an 85% devaluation of the yen. This yen weakness was reverberating throughout Asia as Japan's trading partners would see capital flows increase and their currencies rise. Between 1995 and 1997 the Thai baht, which, at the time was linked to the US dollar, rallied 50% against the yen, which eventually drove Taiwan to devalue. This lead to the subsequent Asian currency crisis. As you will recall this Asian crisis was not just contained to the East. The ripple effects could be felt in Cushing, OK, Moscow, and on a famous trading floor in Greenwich, CT.

In early 1997 WTI crude oil was trading at $25/bbl, which was the highest level since the spike that coincided with the first Gulf War. By the fall of 1998 the price had been cut in half to $12/bbl. This collapse in oil prices had severe effects on Russia's petroleum-based economy, eventually driving a devaluation of the ruble and default on Russian debt.

The financial contagion would produce a flight to quality in US Treasuries and spike in implied volatility that would eventually see the demise of hedge fund Long Term Capital Management that employed highly leveraged fixed-income arbitrage strategies. LTCM was a massive counterparty risk to every large Wall Street primary dealer, and with reportedly holding $125 billion in positions against $5 billion in capital, it nearly brought the US financial system to its knees.

The NY Fed President Bill McDonough orchestrated a bailout of LTCM and Chairman Alan Greenspan cut interest rates to stem the fallout of the crisis. These actions introduced the market to the eponymous "Greenspan Put" which was interpreted as an implied floor under asset prices.

The 2008 financial crisis is a direct parallel to the failure of LTCM. Both contained immense leveraged positions of illiquid securities that were short volatility. Both also were not the result of economic conditions effecting trading positions, but rather a chain reaction in currency markets that saw a rapid widening of spreads in the face of spiking implied volatility.

Thai Baht vs. Volatility Risk Premiums

Source: Bloomberg
Click to enlarge

Since the Abe election the Thai baht is up 20% versus the Japanese yen and is already up 8% on the month for an annualized move of 400%. As I mentioned above the euro is also up 20% versus the yen but is also spiking versus the Swiss franc. Coincident or not, it could be due to Germany's recent decision to repatriate gold from the US. Maybe the selling is coming from Germany who is reducing the needed safety of gold proxy CHF (CURRENCY:CHF) causing EURCHF to spike 4% in a two weeks. The reasons are still not clear. What is clear though is that FX volatility is on the rise and this should not be ignored for its influence can be systemic.

Bloomberg reported that Abe advisor Koichi Hamada said that too much monetary easing and yen weakness could be problematic, and that the 110 level would be too weak. If the 110 level is a soft target, that would still be a significant 20% rally from current levels. If the 2% inflation target is consistent with a level between 140 and 150, that would be a 50% rally. What would that kind of yen depreciation do to the Thai baht? What would it do to oil prices? What would that do to emerging market debt?

Today could be a seminal event as we may be witnessing a central bank transfer of power. The Federal Reserve's monetary policy has been dominating asset prices since the era of easy money began in 1998. We've now come full circle. With the introduction of a 2% inflation rate by the Bank of Japan and a subsequent effort to devalue the yen to get it there, we may be witnessing a tectonic shift in which central bank policy dominates asset prices and risk premiums.

The FX market is very deep and liquid. This kind of volatility is significant, and if it continues, it's only a matter of time until it finds its way into the US capital markets. On Friday the CBOE Volatility Index (^VIX) showed equity market implied volatility to be near the lowest level since the financial crisis. At the same time junk bond yields are making new all-time lows and the spread between high-yield (HY) and investment grade (IG) is very tight, suggesting very low imbedded credit risk volatility. It's not US economic and earnings growth that will derail this rally in risk. Like in 2008 and in 1998, it's a systemic second or third derivative event that the market cannot discount.

Twitter: @exantefactor
No positions in stocks mentioned.
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