Notes From Underground: A New Tapering That Is Needed

Japanese Prime Minister ABE may need to taper, but this would be a fiscal tapering as he may want to take a Greenspanian approach to raising the sales tax and drip feed the increase into the economy. It MAY behoove the Japanese government to make the SALES TAX increase data dependent (sound familiar) and increase it 1% with every incremental improvement in the GDP. The NIKKEI index is struggling as it comes to terms with the projected increase due to take hold next year. Investors are nervous about the negative impact from the tax increase as they remember the last time that the Japanese authorities increased taxes to bring down the DEBT/GDP RATIO. The economy went into a deflationary downturn, even as the sovereign debt level was decreased for a short period of time. But ultimately as growth slowed tax revenue decreased and a negative feedback loop developed.

After last night’s BOJ decision to stay the course, Governor Kuroda raised the issue of the consumption in his post-meeting press conference and the NIKKEI undid its earlier gains and closed down 1% on the session. It seems that investors are worried about the negative impact of the tax increase and thus PM ABE should be cautious about undoing the incipient growth story arising from Japan. If PM ABE would to announce any TAPERING in the quest for revenues, look for the Nikkei to begin its next leg of the bull market. In a WSJ summation of Kuroda’s news conference it was noted that the BOJ governor warned the Abe administration that failing to enact the 5% sales tax next April could result in the market losing confidence in the administration. It could drive interest rates higher and undo all the good that has been accomplished to this point.

Kuroda said: “… it is extremely important for the government to clarify the path of fiscal rehabilitation and to move ahead with fiscal and structural reforms. The BOJ is strongly hoping it will steadily implement them.” It was also noted, “… if the government backpedals on efforts to reduce deficit, markets may suspect that the BOJ is in effect bailing out the government by monetizing debt through its bond-buying program.” The BOJ seems to be weary of destroying its credibility but PM Abe should force a compromise and STEADILY increase the consumption tax. We will wait for further words from the ABE government.

***A MAJOR POINT OF CONSIDERATION: Today I received an e-mail from a long-time reader about the impact of the recent steepening in the U.S. yield curve–the 2/10 being our reference point. The CURVE has widened (steepened) more than 70 basis points since the  Chairman Bernanke’s May testimony when the issue of a possible early TAPERING of the QE program was raised. The question raised by AF is thus: “If a yield curve has a steepening bias, does that support a currency because of better growth expectations or because you can earn more holding than govt’s bonds?”

This is a very important question and I will tell you the answer is messy. It is difficult to time the impact from yield curve movements. Recently, the Australian 2/10 curve has steepened from 42 basis points to more than 140 in a very short time and the currency has dropped more than 15%, so the answer is to ask why a curve is steepening. In the Aussie case, the curve has widened as the RBA has been an aggressive cutter of rates, resulting in a bull steepening which has chased some foreign money out. The recent U.S. steepening has been because of a selloff in the BOND MARKETS as the tapering talk from the FED has frightened holders of debt to liquidate some of their holdings so we have a rise in what Chairman Bernanke would call, the TERM PREMIUM that bondholders demand to hold longer duration Treasury DEBT. Bernanke defines TERM PREMIUM AS “THE EXTRA RETURN INVESTORS EXPECT TO OBTAIN FROM HOLDING LONG-TERM BONDS AS OPPOSED TO HOLDING AND ROLLING OVER A SEQUENCE OF SHORT-TERM SECURITIES OVER THE SAME PERIOD.” (Bernanke speech, March 1)

So it matters as to why the curve steepening is taking place. But my experience of steepening curves it that if it is a movement particular to a single country it will be BEARISH in the near-term for that currency for it reflects that the market believes that the particular central bank is behind the CURVE and push the currency lower. The impact when all curves are acting in concert, as is currently the case around the world. It is harder to come to a definitive conclusion. But for an illustration look to the current action in the most aggressive central bank, the RBA. Again, this is a very difficult issue but one that will bear fruit if you pay attention. The flip side of this picture is the fact that prior to the 2008 credit crisis, the U.S. 2/10 curve actually inverted (went negative), signaling that the FED was overly tight … and a signal that the FED failed to recognize.

Staying with this subject, I wish to bring up the idea that some pundits raise about the recent rise in long-term yields and the pain inflected on bond funds and holders of high-yield bonds and sovereign debt because of TAPERING. Some are of the opinion that this a redo of the huge bond collapse of 1994-1995, when bondholders lost massive amounts of money because the FED unexpectedly raised interest rates from the 3% FED FUNDS level during the course of 15 months (interest rates increased more than 300 basis points). While the recent bonds losses have been substantial, in terms of FED actions and BOND PRICES (from a global macro view) 2013 and 1994 HAVE NOTHING IN COMMON.

In 1994, the 2/10 yield curve FLATTENED DRAMATICALLY WHILE THE RECENT RESPONSE TO TAPERING HAS LED TO A SEVERE STEEPENING. Now the DOLLAR DID NOT RALLY immediately in 1995-1995 but there were other global macro events unfolding that had dramatic effects on the currency markets, so my theory is very difficult to time. BUT I WILL UNEQUIVOCALLY MAINTAIN THAT PRESENT BOND MARKET ACTION IS NOTHING LIKE 1994. The issue I raised the other day was that on very bullish DOLLAR news–the trade data and the about-face by Chicago Fed President Evans on the issue of tapering–failed to rally the DOLLAR. The market seems to be struggling with the U.S. steepener. Yes, other curves are also steepening but if investors want some diversification away from the uncertainty of the U.S. dollar, well, currency values are always relative. NOW ABOUT THE RECENT BIDS IN THE PRECIOUS METALS…

2-101994-gif

U.S. 2/10 Yield Curve-1994-1995

2:10present

U.S. 2/10 Yield Curve–Present

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7 Responses to “Notes From Underground: A New Tapering That Is Needed”

  1. asherz Says:

    Our beloved Fed chairman is caught between a rock and a hard place, much of his and his predecessors own making. Turn off the printing presses and the housing market collapses and the weak recovery flatlines. Keep it going, and the currency continues to lose value.(buying power,inflation). Zirp has resulted in gross misallocations of funds with asset inflation replacing the possibility of investment and job creation.
    Why would Yellin or Summers want to step into this mess?

  2. Mario Says:

    https://yragharris.com/2011/06/12/deflation/
    Rob SYP hits it on the head here. Thank you Yra for providing a coachable/informative place for traders to get some key notes with powerful knowledge that carrys heavy importance for the marketplace around us. In using the market we can all use eachother. Put down a favorite article that pertains to the reading or one that we see as a prospect for what lies ahead. Contact me if you have any further questions mario@vfund.com. Grabbed article above from several years ago as it pertains to deflationary talks in a marketplace that may shed some light on Japan as they are trying to steer clear of the same gorilla the US wanted to run from.

  3. Chicken Says:

    Inversion prior to “crisis”

    I always thought of an inverted curve as a recessionary signal and I don’t think the FED missed it, my belief is the FED created this on purpose.

    ARMS shot through the roof and the wheels began falling off, and ARMS were all banks were offering just prior. Banks were steering even capable hands who didn’t need the extra fractional point, into ARMS.

    That’s how I remember it. Inflation, aside from housing(low rates effect) and perhaps a couple of areas now famously realized as being manipulated such as power generation, seemed tame.

    So half of the carefully scripted media garbage we read is false, the other half is rear view mirror..

  4. yra Says:

    Chicken—but even Greenspan yelled for the call to arms

  5. john bougearel Says:

    Yra, is it possible the RBA is aggressively cutting rates to get ahead of the Fed tapering asset purchases in Sept, knowing that trillions of derivative trades are tied to low long term US interest rates, so that they better do something stimulative now to soften the blow coming?

    Along that same vein, couldn’t the steepening in yield curves around the world be related to US interest rates having a steepening bias.

    I mean here is the chance for the Fed to cut its asset purchases in half or more for a few quarters and maybe more because the US debt has shrunk from 1.48T to 695b over the past year, and that the trajectory of US debt is going to continue to shrinking over the near term. This is a 750b fiscal US contraction that is rippling throughout the world, and in particular emerging markets.

    I am a little out of my depth here trying to connect the more than 50% contraction in the US debt to 50% less debt to finance and money to print, so less dollars to go around the world….its a sort of fiscal contraction being felt across the world.

  6. » 8.9.13: SP 500 Earnings: Forward Estimate Growth Rate Continues to Trek Higher Fundamentalis Says:

    […] not acting as we had hoped, but still long the DXJ and EWJ. Here is Yra Harris’ blog (Yra is a CME trader and frequent Rick Santelli and CNBC guest) on the Japanese predicament. Still […]

  7. yra Says:

    John–on the Aussie end,I think you raise a interesting theory but I just don’t sense the concern is with the U.S.–the rba jusr stayed too tight for too long.The U.S has a steepening bias because the FED will not be raising the fed funds rate for a long time and with less fed buying even though less treasury debt hitting the market,bond shorts are going to feel emboldened but not yet to the degree they could.This is why the FED is in a very difficult position

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