Notes From Underground: An Open Letter To the G-7

Every G-7 or G-20 meeting homage is paid to the idea of free markets via the market driven value of each nation’s currency. This is hogwash of the highest order in the world of central bank asset purchase programs. The clarion call is that QE is a domestic-based program meant to meet the inflation target set by the nation’s policy makers and any impact on a nation’s currency is just unintended consequences of keeping a country out of a potential disinflationary cycle. Every central bank statement except the U.S. has a sentence or two about the relative value of a nation’s currency and if too strong then concern about a strong currency being a headwind in meeting the illusion and capriciousness of that 2% inflation target.

Case in point: On Monday night, the Reserve Bank of Australia released its latest interest rate decision. As I rightly assumed, there was one sentence of the current Aussie dollar rate and its relative value to the major currencies and its key trading partners. (“The Australian dollar remains in the upper end of the range of recent years.”) Ahead of the meeting the currency has been steady this year versus the euro and the dollar, 1% lower versus the KIWI, 4% lower against the Canadian dollar, weaker versus China and 7% stronger against the YEN.

Overall, the Aussie dollar is a non-event but concern for it on a trade-weighted basis will keep the RBA holding interest rates at 0.10% while exerting yield curve contol on the rates out to three years by actively buying three-year Aussie bonds. Regardless of the RBA, we at NOTES FROM UNDERGROUND are most concerned about the WEAKNESS of the Japanese yen against the majority of the world’s more important currencies. Is the YEN weakness in a WEAK DOLLAR environment a result of rising inflation in Japan (and thus negative real yields)? No, as Japan most probably has the best record on inflation while rising inflation in Germany is leaving German bond holders with increasing NEGATIVE REAL YIELDS.

The U.S. has much worse NEGATIVE real yields. The list goes on. Why is it that the YEN remains the weakest of the world’s developed currencies? The riddle is solved by analyzing the BOJ’s balance sheet. In the Mainichi, a Japan National Daily, there was an article on Friday titled, “Bank of Japan Assets Quadruple to $6.5 trillion Under Kuroda’s Aggressive Easing.” The story details that in an effort to reach its “mystical 2% inflation target,” it increased its bond holdings by 9.5% to 532.17 trillion yen and boosted its ETF purchases by 20.7% over the past year to 35.88 trillion yen. (Note, the ETFs have a market value of 51.51 trillion yen leaving the BOJ with a sizable profit up to this point.)

The BOJ’s activity is not alchemy like the Swiss National Bank, which directly purchases foreign equities and bonds with freshly printed Swiss francs in an effort to keep its currency  from dramatically appreciating. The Japanese manipulation of its currency is more insidious. The Japanese savers, insurance companies and pension funds are the world’s largest creditors/investors. As the BOJ increases its BALANCE SHEET, Japanese investors are forced to look outside the country for investment opportunities as there are few BONDS to buy and the idea of racing the BOJ to acquire Japanese assets at a reasonable price is a fool’s errand.

This leaves foreign markets as the the only alternative. The more foreign assets that Japan’s investors purchase the weaker the YEN on a relative basis. If my THESIS is correct there could be some increased volatility in all the world’s YEN crosses — eur/yen, chf/yen, cad/yen, aud/yen, and, most importantly, YUAN/YEN. (The Chinese currency has appreciated 15% versus its Japanese counterpart over the past year.)

The YUAN‘s rise is not a bad thing as it supports my view that the Chinese have been promoting a stronger currency while it increases the buying power of its middle-class consumers. The imports from Japan are not raw material-based but manufactured goods making the argument about China’s designs of YUAN strength ever more credible. But, how high is China willing to allow the YUAN/YEN cross to rise before signaling its displeasure.

In June 1998, the U.S. Treasury under Bob Rubin intervened to weaken the YEN as Bill Clinton was heading to Beijing for talks with the Chinese. (At the time, the YUAN/YEN cross was trading at 17.45 yen to the yuan.) This is something to keep in mind for it would impact several asset classes, especially foreign bonds, as Japanese investors have chased nominal yields across the globe.

***Before I forget: Over the weekend the People’s Bank of China ostensibly raised the reserve requirement for foreign assets to 7% from 5% in an effort to slow the appreciation of the YUAN. It appears to be a superficial effort and really meant to send a signal to investors to not push for too rapid a rise in the Chinese currency. Many analysts were out working their models using the increase to suggest that a 2% rise in the reserve ratio would cause banks and others to hold an extra $20 billion in reserves, which would slow the economy. HOGWASH! The Chinese economy is far too big and dynamic for such an increase to act as a drag on spending. The CHINESE economy is trying to become more consumption driven which needs a stronger currency.

Again, the policy can be found in how concerned the PBOC is about the current YUAN/YEN level as China is busy importing Japanese manufactured goods. The G-7 needs to be concerned about any trade advantage the Japanese are accruing through the policies of the BOJ and Ministry of Finance. Nominal yields almost act as an agent of fungibility in a zero interest rate world. The G-7 has been warned—now what is the potential fallout?

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15 Responses to “Notes From Underground: An Open Letter To the G-7”

  1. Arthur Says:

    If China’s economy is so strong, why isn’t its currency stronger?

    • Yra Says:

      Arthur –thanks but as I read it I think it has any flaws–the YUAN rise has not just kept pace with the other currencies—the EURO yes but the YEN absolutely not—in one hour I am doing a podcast with Michael Pettis to be released in Notes as soon as possible—-but I think many get the YUAN story wrong—-see a 2007,June in the Far East Economic Review an article by Professor Pettis—China’s Last Option:Let the Yuan Soar

      • David Richards Says:

        Yra, that’s interesting because in an article in China last month, a top PBOC person let it out in the press that they’re seriously considering a genuine Strong Yuan Policy (my words). Did you hear? That article was retracted from the local press hours later, but not by the speaker, PBOC or govt.

        As we’ve discussed before, Chinese policymakers are as afraid of inflation as US policymakers are afraid of deflation. So we should see policy divergence, as we do now and have for the past year.

      • Arthur Says:

        Yra, waiting THE podcast. Know prof Pettis very well… China-turning inward could be really costly.
        Last 25 years I’ve been very very ery bullish on China, not anymore. The macro & China’s story is changing…

      • Yra Says:

        David and Arthur—when Chris Woods was its key editor of the Economist I was an avid reader for it really challenged.But I agree with Arthur –read those you are most likely to disagree with as you will actually learn something if you dig deep enough—again not validation but discourse

    • David Richards Says:

      Sadly, The Economist seems like a bit of a rag nowadays. I question its hypothesis and facts. First, who has ever proven that currency strength/weakness is tightly correlated with economic strength/weakness? Second, in fact the trade-weighted Yuan Index made a fresh 6-year high this week, BOOM.

      Moving on to something related, yesterday Russia announced a new Zero US Assets Policy that requires Russia obtain non-dollars for payment of Russian resources & commodities – or else requires immediate FX conversion for contractual receipts in USD. And it requires that Russia entirely liquidate within one month all of its remaining dollar assets and then not hold any US assets whatsoever thereafter – roughly comparable to Biden’s new policy announcement the same day banning Americans from holding most Chinese assets including some globally-coveted Chinese investment grade bonds that pay exceptionally high interest in a rising currency; a rarity nowadays that’s caused large investment capital flows into China throughout 2020-21 (in fact China displaced the US last year as the global leader for FDI, foreign direct investment).

      And so here’s the new benchmark for Russian reserves and sovereign wealth fund:
      40% Euro
      30% Yuan
      20% Gold
      10% Other
      0% US (currently 35%)

      • Arthur Says:

        God bless The Economist! I read it because it is an amazing gymnasium for the mind; 80% I disagree with them, that’s how they help me make money 😉

        It’s like boxing, they’re a wonderful sparring.

        Yra’s blog, The Economist, Geopolitical Calendar are a must… my humble opinion.

      • David Richards Says:

        Arthur, I absolutely agree with your idea that reading sources with which you disagree is worthwhile. Better than being in an echo chamber. How else can we learn or see how we might be wrong and change our mind? As being dogmatic is a poor approach to investing.

        For example, I’ve studied the latest stuff from the brilliant Lacy Hunt (for eg: and Dr Hunt is still very bullish on USD Treasuries as a core investment. He makes a good case based on deflation, but in the end I think I see a fatal flaw in his analysis and I’m on the other side, both technically and fundamentally (too long and complex to discuss here unless someone is keenly interested). But that’s what makes a market. As I expect UST will wind up being brutal especially for offshore investors and that USD will eventually collapse. It’ll be epic. BICBW. We’ll see.

  2. RondoAZ Says:

    Whew. A lot to chew on here. I am certain that I don’t know how the mixture of clear inflation based on both demand and a screwed up supply chain of materials and labor in the U.S., and the Fed’s promise to keep rates low, and the Biden (or whoever is running him – Xi?) administration and demoncrat congress moves to spend as though $ grow on kudzu, will impact equity markets. Don’t tell me to reread Strunk and White – I know that last sentence isn’t worthy.

  3. ShockedToFindGambling Says:

    Great analysis.

    Yen weakness may be a harbinger of overall USD strength.

    Weekly $DXY chart trying to form H&S bottom.

    Very few USD Bulls.

    • Yra Says:

      Shocked—I am not leaning to a Dollar bullish scenario but the YEN crosses are certainly worth watching especially Eur/YEN as the Germans and Japanese actively competing for the Chinese market in high quality manufactured goods.I know you see a developing DOLLAR bullish pattern but the present policies both monetary and fiscal keep me looking to sell dollars.But I will say that today’s news about a compromise on corporate taxes to get an infrastructure bill is a positive development for politics is the art of compromise

  4. TraderB Says:

    People are now migrating to alternative means of barter (both liquid and illiquid) in a somewhat “orderly” fashion.
    -Real Estate

    I fear for what a “disorderly” migration might look like.

    How are governments planning to utilize all of the gold they have been holding/acquiring now for years? I would love to see more discussion in terms of the mechanics and timing of these solutions.
    – a gold pegged digital currency
    – a gold backed Yuan
    – gold as collateral for the Eurobond

    Central planners would only utilize these solutions as a last resort. Is it fair to assume that these conversations have already begun?

    • Yra Says:

      TraderB—I believe these conversations are taking place especially as China and Russia seek to disrupt.But to read Brainard opining on a Gold backing to Stablecoin is of more than passing interest

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