Notes From Underground

Late Thursday night, the BOJ surprised the markets with an acceleration in the pace of increasing the monetary base. The bank will increase its asset purchases to 80 trillion yen from a previous annual amount of 50-60 trillion yen. The bank will also purchase ETFs and J-REITs at an added 3 trillion yen a year, a massive amount of increase of its balance sheet. In Japan the BOJ‘s program is referred to as QQE for it is both a quantitative and qualitative program. As it is pointed out, the BOJ will wind up owning 75 percent of the JGB market as banks and pension funds unload BONDS onto the ultimate buyer of last resort. When Japan was in a deflationary economy, owning BONDS made perfect sense as negative prices gave rise to REAL HIGHER YIELDS.

Now with inflation running at 1 percent and JGB yields closing at 0.45% on Friday, real yields on long-term Japanese assets are now a negative yield. In addition to the BOJ QQE acceleration, the GPIF (Government Pension Investment Fund) announced it would be reallocating its massive domestic bond portfolio to purchasing a net of 50 percent equities and an increased amount of foreign bonds. It will be easy for the GPIF to do the rejiggering because the BOJ will be a willing buyer of JGBs at extraordinary high levels. (THE JGB FUTURES CLOSED AT A WEEKLY RECORD HIGH FOLLOWING THE BOJ’S DECISION.) The Japanese bond market is a worthless barometer of financial conditions because the market has a willing, ready and capable buyer. If the BOJ and Governor Kuroda are successful in generating a higher inflation level, then the GPIF is acting with great wisdom in getting out of fixed income assets and into domestic and global equities.

IF THE BOJ AND THE ABE GOVERNMENT ARE SUCCESSFUL IN ENGINEERING AN ESCAPE FROM THE GRASP OF ECONOMIC MALAISE, THEN OWNING JGBS IS A TERRIBLE INVESTMENT. THE BOJ IS THUS BACKSTOPPING THE POTENTIAL LOSSES OF THE ENTIRE JAPANESE FINANCIAL SYSTEM BY ITS ENORMOUS BOND PURCHASES. This strategy can have dire consequences for the ULTIMATE OUTCOME IS THE BOJ MONETIZING THE JAPANESE DEBT. But the initial response of the market to the BOJ action was spot on as the Nikkei rallied more than 5 percent and the YEN weakened by over 2 percent. The world’s equity markers rallied in anticipation of huge buying by the Japanese pension plans and the hope of further quantitative easing by other central banks.

Maybe the most important outcome of the BOJ action will be the pressure put upon the European Central Bank. President Draghi has been fearful of initiating a powerful QE program because of threats from the Bundesbank and private German citizens about the ECB acting beyond its legal authority. The Japanese have now provided an excuse for President Draghi to cast away any fears and proceed to an extremely robust QE program. Even the German’s will be weary of the Japanese as the EUR/YEN cross will be indicative of pain for the German auto sector. The EUR/YEN has been stuck in a range for the last several months but Friday’s price action pushed the cross to the high-end of the range. If the ECB fails to respond to the BOJ‘s actions to weaken the YEN then we will probably test the EUR/YEN high made the week of December 23, 2013 at a level of 145.69 YEN/EURO (presently trading at 141.20).

When the YEN first began its response to Abenomics it weakened quickly and Japanese auto stocks rallied, especially in relation to its global competitors. Even though the Japanese auto industry off-shored a great deal of production, a weakening yen will provide Toyota and others with great pricing power. Repatriating foreign profits until Japanese corporate coffers will see a DOLLAR or EURO buying much more yen, all flowing to the bottom line. The European economy is under great strain due to high unemployment and a large debt hangover. Will the BOJ‘s decision provide the rationale for aggressive ECB action? Draghi’s days of using words over cash are nearing an end. There is an ECB meeting this week and previously I thought the ECB would wait until December for any new program I am beginning to think that the Japanese have increased the pressure, or maybe this may all be coordinated by the central banks.

The race to the bottom of currency levels is on as last week we had the Swedish and Japanese announce their intentions to fight deflation with the help of depreciating currencies. Also, the RBNZ Governor Wheeler called the KIWI DOLLAR significantly overvalued. Oh, it seems that global stock markets are the last haven for investments, rather own a tangible asset with a dividend. This has been the mantra of investors since global interest rates have resided at ZERO. Oh what has the world of central banking in the age of fiat currencies wrought?

***A note to my readers: I have maintained that GOLD needs to hold at 7150 yuan to an ounce of GOLD, which is where the metal settled on Friday. I fielded several phone calls and e-mails pondering how GOLD reacted so negatively to the BOJ announcement. It is very perplexing but the simple answer is as it has been since February 2013: GOLD is not deemed a haven, a store of value when equity markets are providing a place of value with great upside potential and a dividend to enhance the return. Many intelligent investors have missed this and sustained a belief in gold at a severe loss of money and opportunity. As the central banks act to devalue their currencies the fundamentals of GOLD improve but the technicals deteriorate. As the best technician I have ever known was fond of saying: “IF YOU ARE RIGHT AT THE WRONG TIME YOU ARE WRONG.”

Yes, the fundamentals of gold are glaring because it is not inflation that drives GOLD but the act of central bank policy to deter deflation that most scares investors. The stock markets have proven to be a better antidote to central bank policies. Until stocks also suffer from investor disillusionment. Three weeks ago investors were fearful of falling equity prices but that fear has been relieved by the continued power of cheap money. Every central bank cannot to continue to depreciate its currency. Something will have to give. Presently, the BOJ, RBNZ, SWISS, BANK OF ENGLAND and ECB would like a weaker currency. Is the FED going to be the one bank that holds firm and allow all the others to attain a pricing advantage?

A hat tip to KM, who called with the ultimate question on Friday: What Did Chair Yellen know about BOJ policy intentions while in the FOMC meeting? Remember too, that the BOJ decision was decided by a 5-4 vote, which is very unusual for a consensus-driven institution. (I will have more on Japan tomorrow). If the BOJ decision was coordinated with all the central banks then we can certainly expect aggressive action by the ECB because Europe is presently in the middle of a renewed economic downturn. Indeed, what has the BOJ WROUGHT?

Tags: Abe, BOE, BOJ, ECB, Eur/Yen cross, Euro, Fed, Gold, JGBs, kiwi dollar, Kuroda, Mario Draghi, QQE, RBNZ, SNB, Wheeler

This entry was posted on November 2, 2014 at 7:12 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.