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Wednesday, 18 October 2017

On turning Japanese, the Fed, the renminbi, the Bund and Irish 'ayes'

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As we entered the current crisis some five years ago, there was much talk of Japan and its lost decade. We were assured that a “Japanification” was not on the cards and that the aggressive stimulus offered by the monetary authorities would protect us from a fate worse than death.

Although sceptical – no surprise there, I suppose – I used to refer to the 2002 Federal Reserve discussion paper which had been commissioned by Alan Greenspan when still Fed Chairman and which looked at the errors that had been made by the Bank of Japan when faced with the implosion of the asset price bubble and the subsequent near collapse of the banking system. It is called “Preventing Deflation: Lessons from Japan’s Experience in the 1990s” and is a riveting read for insomniacs.

One of the key conclusions of the study was that the BoJ was busily sticking to its remit of fighting inflation when it should have been focusing on stimulus and that it missed the inflection point, thus condemning the country to negative growth and, far more dangerously, persistent deflation.

Keynes taught us that markets can remain irrational for longer than we can remain solvent and hence I believe that it is too early to position the reversal of the Bund rally.

With this in mind, the Fed strode into the crisis with all guns blazing and, despite all the criticism which Ben Bernanke has endured, the 1920’s style depression which many had predicted has, so far at least, been avoided. That the debt clock is ticking faster than ever though, is another matter entirely.

As home of the sole reserve currency, the United States has been in a privileged position in terms of its debt but a huge blow has been dealt to that position with the announcement that the Chinese renminbi will henceforth be quoted directly against the Japanese yen. The camel’s nose is in the tent and I suspect that any further weakening of the unassailable leadership position of the dollar will, before long, begin to call into question the sustainability of America’s overall debt position and eventually its pricing. Cutting the dollar out of Sino-Japanese trade is not just a minor footnote; it is the title of a whole new chapter yet to be written.

Bund reversal?

Meanwhile, as Europe still denies “Japanification”, it might be interesting to compare the German Bund yield curve with that of JGBs. Front-end German interest rates are now trading through those of Japan. It might be splitting hairs but the 2yr JGB has an 0.1% coupon whereas the German 2yr now has a coupon of 0.0% and trades 6bps rich to Japan. The 3yr yields are flat and by the time we get to the 10yr maturity, German Bunds still yield 50bps more than their Japanese equivalents.

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Source: YouTube via IFR editors

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Just a year ago, that yield spread was closer to 2%. However, the irony about the eurozone is that the stronger the economy, the lower the rates. To use an Ephraim Kishon quote in a slightly different context to the original, the parents eat sour grapes but the children have good teeth. On that basis, it’s hard to argue that long German rates might not converge with those in Japan. Although the 10yr is still 50-odd bp higher, 30yr rates remain only 12bp apart at 1.92% and 1.80% respectively.

The key question is whether Germany is critically overbought?

If the Eurozone crisis eases, then the flight to quality trade has to be reversed. If it sharpens to the extent that the single currency begins to break up, then yields will also shoot back up again. An easy short?

Keynes taught us that markets can remain irrational for longer than we can remain solvent and hence I believe that it is too early to position the reversal of the Bund rally. As a collective, Europe faces a weak banking system and low or no growth and as such, it looks just like Japan. I know, I know, the two cannot be compared and I also know that it is politically incorrect to do so. The European economy is far more open than the Japanese one ever has been and therefore it is more exposed to imported inflation. Consumer price inflation might be positive but, within the collective, that is probably not the case for asset price inflation, especially not for real estate. To hear the ECB even mentioning inflation has me worried; I hear the BoJ all over again as it was so busy checking its rear view mirrors that it missed noticing that there was no bridge over the chasm ahead.

Irish ayes

Tomorrow sees the Irish referendum on the European Stability Treaty. The polls predict a comfortable victory for “Yes” campaign which is backed by all the main-stream centre and right wing parties. The left and Sinn Fein are in the “No” camp. Polls have a 57%/43% split in the vote in favour of the proposal although pretty much nobody actually understands what the implications are, one way or the other.

The Irish have a habit of voting “No” on issues they can’t get their head around but I think the risks of the referendum being defeated are remote. Anyhow, what difference does it make as the government will just come back again and again until it gets the result it wants.

I recently took a spanking at the hands of a reader on the issue of democracy in which I questioned its efficacy in dealing with certain economic issues and where he seemingly argued that the answer to most problems is more democracy and not less. I am confident that the Irish voters will deliver the expected result for the right reasons.

However, in a democracy, the people delivering wrong result is for the right reasons too and the habit of the Dublin government to resubmit referenda until the people do what they are supposed to does leaves me scratching my head. Maybe the Irish will vote “Yes” tomorrow because they perceive than in an age of austerity it is financially inefficient to have to run another referendum on the same issue later on. I doubt that to be the case but it is not entirely impossible, is it?

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