Tag Archive | "Bond Markets"

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Stimulus Uncertainty Driving Markets

Every statistical report about the state of the economy seems to correlate with the possibility of another round of quantitative easing. The markets appear to be treading water until the Federal Reserve makes a decision about the merits of Quantitative Easing Round 3(QE3).

Today global stocks were stable but US bond markets lost some ground due to uncertainty about the possibility of another round of easing. The irony of this dilemma is that fiscal conservatives think the Federal Reserve has already overstepped its bounds. Meanwhile, fiscal liberals think the Fed should do more. On Wall Street, the sentiment is that the Fed could and should do more.

Of late, equities are up. The primary reasons are the sense that something positive will happen in the euro zone and that the Fed is poised to unleash more weapons from its arsenal. However, what is unclear is what weapons the Federal Reserve has left.

Factors contributing to today’s optimism about another round of easing are driven by a report from the New York Fed that manufacturing in the state had contracted for the first time in 10 months. However, this report was countered by another report indicating that the recovery might be stronger than expected. Industrial output in July rose by 0.6 percent.

Equity traders are wagering that the Fed will intervene with a stimulus package to purchase bonds and jumpstart the economy yet again. This strategy has been denounced by Republicans and hailed by Democrats. This raises the question of the Federal Reserve’s political influence. The Fed is an apolitical entity whose primary concerns are the economy and unemployment.

These are the only triggers that should influence the decision to implement a stimulus. The economy is teetering but it is not crashing. The real incentive for the Fed could be unemployment. It has been anticipated that the Fed might act if the unemployment rate does not decrease. This would be a political assist to President Obama and thus is distained by Republicans candidates but welcomed by Republicans on Wall Street.

The real question that only the Fed knows is what tools are available. Analysts project that the following actions are probable:

  • Extend the guidance rate until late 2015. It would be unusual that the Fed would forecast events three years in advance and with Bernanke’s term as Fed Chairman expires in 2014.
  • QE3 is expected to be announced and consist of a $300 billion purchase of mortgage-backed securities. Side effects would include a strong probability of inflation and impair liquidity in the country’s bond markets.
  • Changes in the way the Federal Reserve presents its minutes. The Reserve minutes usually include opinions from non-voting members which conflict with the decisions of voting members and can present inaccurate assessments.
  • The Fed has the authority to lower the interest on excess reserves (IOER). The Fed can lower this rate by as many as 10 basis points which would, in turn, lower front-end rates.
  • The Federal Reserve has the capability to provide long-term loans to the private sector through banks who can post suitable collateral.  These loans pass through the discount window. This plan has worked well in the UK with the Bank of England’s “Funding For Lending window.”

There are other, less likely options. Intervening to weaken the dollar and make US exports more desirable is one possible strategy. The fed also has the authority to impose a ceiling on Treasury and mortgage backed security yields. And, of course the Fed can raise the inflation target, a pretty unappealing option that will require modifications at some point.

What makes the Fed’s intervention puzzling is the trigger points. There does not appear enough economic distress to unleash the stimulus. The only factor that justifies QE3 in some form is the unacceptable unemployment rate.  If the Fed acts and unemployment decreases, the Republicans will claim political intervention.

Anyone who has followed Ben Bernanke’s courageous conduct in the face of adversity will know that politics is not in his playbook. Without his steady, guiding hand, the economy would have tanked long before today. Frankly, this is a man that has carried the weight of the world since the Lehman collapse. Ben Bernanke is a serious man and a brilliant scholar regarding the Great Depression. His brilliance is one significant reason that the globe did not experience a global depression that would have overshadowed the Great Depression.

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BoE, ECB and The People’s Bank Act

In response to data suggesting a global slowdown, the Bank of England, the People’s Bank of China and the European Central Bank made conventional moves to attempt to breathe life into staggering markets.  The People’s Bank lowered its interest rate by 31 basis points to 6 percent.  The ECB trimmed rates to 0.75 percent, a historic low. The Bank of England left its interest rate at 0.50 percent but announced, the bank would begin another round of quantitative easing.

Britain is expected to print 50 billion pounds and use the funds to purchase distressed assets.  Previously, the Bank of England used quantitative easing to flood the market with 325 billion pounds.  Flooded with negative economic data, the ECB vowed to maintain their interest rate but stopped short of investing in upcoming bond markets or putting any cohesive remedies on the table.

ECB president Mario Draghi has continually stressed the need for a comprehensive overhaul of the euro zone debt crisis. Draghi appeared to be delivering a call to unified action to euro zone members. At this time, the ECB has no plans to revisit national bond markets.

Draghi’s frustration with the euro zone’s unwillingness to put a long-term program in place has come to a head.  On Thursday, Draghi told the media that new information pointed to deepening financial difficulties in the region. “We see now a weakening basically of growth in the whole of the euro zone including the country or the countries that had not experienced that before.”

Draghi emphasized that it is not just the southern tier of the euro zone that has economies fighting recession. The euro zone economies are no longer growing.  Most of the countries are either in recession or are headed there. Draghi appears to favor a combination of growth and more reasonable terms for floundering euro zone members.

The central banks of England and Europe were expected to act but China’s rate-cut surprised analysts.  The People’s Bank lowered rates last month, but in anticipation of next week’s data, the bank acted. It has been projected that China will suffer a six consecutive month of sliding growth.  It is believed that China’s second quarter will show the lowest growth since the collapse of Lehman Brothers.

Bank lending in China has experienced very little demand.  The interest rate decrease is intended to inspire businesses to grow.  The central bank previously lowered the reserve requirement ratio (RRR) to 20 percent.  This move freed more than 1.2 trillion yuan for new lending.  The bank is expected to lower the RRR to 19 percent before year’s end. However, analysts were quick to say that the central bank’s willingness to cut deposit and lending rates is more incentive than the RRR changes.

The People’s Bank launched a massive 4 trillion yuan spending bill in late 2009.  The spending policy has caused large volumes of bad debt that the country’s banks are struggling to retire.  However, it is believed that a continuation of poor economic data will spark some form of quantitative easing, which China has the resources to manage.

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Euro Leaps Higher

For followers of market driven data, the news from the euro zone presents puzzling trends.  The European Union and the euro zone are struggling with high unemployment, low manufacturing, low consumer confidence, a debt crisis that expands every day and a volatile euro that defies logic.  Most of the economies in the region suffering their 3rd, 4th or 5th recession in the last six years.

Citizens are walking away from metropolitan areas and returning to the countryside soil, much of which has been neglected for 50 years or more. Unemployment among the young is more ten 30 percent.  For university graduates or young persons with expertise in a trade, the only unemployment solution is to escape.  Only one euro zone political leader has held office since 2008.  And, that leader, Angela Merkel, has lost the confidence of her constituents.

Investors want the euro zone to succeed but they are out of patience.  Feeding off baseless political rhetoric, sophisticated investors are shying away from most of the region’s bond markets.  Italy and Spain have been forced to offer unsustainable yields on both short and long-term bonds. Spain is in the midst of a banking crisis that could collapse at any time.  The euro zone has committed more than 100 billion euros to rescue Spain’s banks, but thus far it appears as more idle talk rather than anything else.

Euro zone finance ministers have lost their credibility while the European Central Bank and the International Monetary Fund and the European Union have poured more than 1.5 trillion euros into losing propositions. Having gone about as far as possible, sovereign debt originators are now turning to international and private investors to keep the region functional.

The G20     

At this week’s G20 summit in Mexico, the positive spin continued.  European leaders told anxious economies that a plan was in the works to develop “concrete steps to integrate its banking sectors.”  Throughout the debt crisis, the only consistent behavioral pattern for the euro zone has been to assess what international investors want and then announce a remedy along those lines.  Time after time, these announcements have hit a roadblock and been left for dead.

President Barrack Obama and Treasury Secretary Timothy Geithner echoed support for this initiative but Obama was quick to emphasize that this plan did not resemble a silver bullet.

IMF chief Christine Lagarde, whose bank just pledge 1.4 billion euros to struggling Ireland, was enthusiastic about the announcement. “It doesn’t matter if it takes a long timer.  It has got to be done well.”  Lagarde added that all short term remedies had to be consistent with the long-term plan. This is the prototype that advocates of growth have been awaiting. This strategy could also come to the aid of Greece and Portugal who may receive extended terms to their bailout packages.  This sounds more like the plan that France’s Francois Hollande recommends than the pan Germany’s Merkel supports.

After pain received a pledge to capitalize the Spanish banks, it has become apparent that the country needs a more comprehensive bailout because the government cannot meet its obligations. While the euro zone could survive a Greek default, it will not survive a Spanish default.

To complicate the landscape further, Italy has now asked the European Union for assistance with its sovereign debt obligations.  These funds could conceivably be issued by either the European Financial Stability Facility (EFSF) or the European Stability Mechanism. The funds would be invested in the purchase of Italian bonds and thus reduce the yield for short and long-term debt.

Italy’s president Mario Monti said the EFSF or ESM investments were only to be deployed to countries that are compliant with the austerity cutting measures required by the euro zone members.  Monti does not want these investments considered as part of a bailout package. Between the ESM and the EFSF, there would be nearly one trillion euros ready for investment by the end of this month.

The fate of the euro and the euro zone falls into the hands of Germany’s Merkel. The Chancellor must explain why her vision of the euro zone has changed from pro-austerity to pro-growth.  This strategy is not popular with Germans who are the cornerstone of Europe, the world’s richest economic entity.

Merkel received heated feedback for her announcement earlier in the month that supported extending Spain’s time frame to reach the country’s targeted deficit reduction targets.  The success of this new, long-term initiative will certainly determine Merkel’s legacy and political future.

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Italy’s Woes Foretell Rough 2012

Since taking over as Prime Minister of Italy, Mario Monti has drawn high praise for the implementation of his bold austerity measures.  However, the cuts have not resonated with investors in the country’s troubled bond markets.  After an encouraging 6-month sale on Wednesday, Italy anticipated a stronger longer-term auction on Thursday.

Investors remained stubbornly cautious as the 10-year bond sale dipped just under the 7 percent mark to 6.98 percent.  The 10-year bond pattern bears a striking resemblance to the performances that led to the demise of Greece. 

Italy’s three-year bonds were in greater demand as the yield fell two points to 5.62 percent.  The demand was steady as the three-year bond yield dipped well below the 7.89 percent paid at the November auction. 

Monti tried to put a positive spin on the bond sale but there is little reason to celebrate.  The trading was light. The auction fell short of the projected sale of 8.5 billion euro settling around 7 billion euros in volume. 

The disappointing volume and high yields on the 10-year notes point to serious problems in 2012.  The country debt to GDP ratio is an unsustainable 120 percent, barely beating Greece’s debt to GDP ratio.  Also of great concern is the fact the European Central Bank (ECB) has been pouring euros into the banks in the region.  While Italian banks are the main holders of the country’s debt, Monti is already calling for an increase in the European Financial Stabilization Facility (EFSF).

Italy is staring at the maturation of 150 billion euros in bonds between February and April.  

Monti has implemented tough austerity measures that have frozen pay in the public sector, but the Prime Minister is up against stringent labor laws.  The labor market for youths is paralyzed as part-time work is all that is available.  Both the public and private sectors of the euro zone’s third largest economy are notoriously inefficient.

Monti’s goal is to balance the budget by 2013.  His 33 billion euro spending cut is just the first step in what promises to be an uphill battle.  Monti described the two-day bond auctions as “slightly positive.”

In other developments, Italy’s business confidence level hit a two-year low.  Italians are bracing for another recession that will undoubtedly sink the country into another tier if recession.

Monti told reporters that he would now start working on increasing growth.  The Prime Minister will be plenty busy on that score.  Italy’s GDP has not grown in three years.  This reality exacerbates the debt crisis.

On Thursday, the euro hit a 15-month low before receiving a boost from stronger than expected economic news in the U.S.  The euro settled flat at $1.2936.  Some analysts are suggesting that the euro will fall to the $1.20 level during 2012.

U.S. Data Better Than Expected

The disappointment in Italy was tempered by surprising news about the US recovery.  Of particular interest was a surprising rise in housing sales in November.  Home sales reached an 18-month high. At this point, housing prices remained low but any move in the housing market is regarded as a bonus.

The Chicago PMI measure financial activity and uses this gauge to evaluate business conditions in the country.  The Chicago PMI exceeded all predictions and sent the thinly traded global markets into positive territory. 

With this news, the euro climbed back from and sent FTSEurofirst 300 up by 1 percent at 992.78.

U.S. equities rose 1 percent as the DOW rose 104.75 to 12,256.16.  The S&P 500 Index gained 9.72 points as the Nasdaq Composite jumped up 18.03 points to 2,608.01.  Trading remains light as investors are holding their profits through the year-end.

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Armageddon 11 Days Away

 No matter how the rhetoric goes, the facts will show that House Speaker John Boehner and Republicans have walked away from the debt ceiling and spending cuts.  The country now has 11 days left before defaulting on the United States debt and a significant drop in the country’s AAA credit rating.

While Boehner and Obama agree on very little, they profess to agree on the importance of not defaulting.  The repercussions of such an action would cause tremors throughout the global economies. 

Unfortunately, Boehner’s caucus contains a minimum of sixty members who seem to feel default is acceptable.  These 60 Tea Party members have left Boehner hanging out to dry and the House Speaker has tried to negotiate in good faith.  But, there is no doubt, the Speaker is fighting for his po9litical life. 

The Tea Party has most likely damaged the Republican Party permanently.  On the other end of the spectrum, it has been reported that in his efforts to meet Boehner halfway, the leftist extremists within the Democratic Party are said to be quietly holding firm in opposition to projected cuts in Medicare, Special Security and Medicaid.

The Grim Reaper

At 5:30p.m. on Friday, Boehner finally returned a call to the President and said that the proposed deal in play was not going to happen.  This meant that after presenting the terms to his Caucus, he could not get enough support.

Boehner suggested that the President had increased the revenue by $800 billion compared to an agreed-upon $1,200 billion.  Boehner’s caucus would not approve such action.  Boehner waited until after the markets closed before delivering his message to the President.  If a resolution is not created over the weekend, equity and bond markets could plummet Monday morning.

Obama immediately took the message to the public in a strong, passionate message pointing the blame squarely and rightfully on the Republican Party.  Minutes later, an exhausted Boehner put together an unbelievable retort.  The President’s theme was that a deal was on the table and as the nation anxiously followed the negotiations Boehner and Eric Cantor walked away and refused phone calls as men in hiding often do.  Had the market been open when Boehner presented his news, there is little doubt that they would have spun lower.

Credit Ratings Lowering the Axe

To make the situation more complicated, credit agencies are unimpressed with the tone in Washington.  Moody’s has already said that a short-term fix will not prevent lower credit ratings.  These ratings agencies want a long-term solution and a debt ceiling increase.   

Despite repeated warnings from the Secretary of the Treasury and the Chairman of the Federal Reserve, there remain Tea Party members who would jeopardize the country, the elderly, the poor and the military personnel in the field.  One presidential candidate, Michele Bachmann, has said the default is acceptable.

If there is a default, it seems like the first wages to be halted should be wages to Congressional members and their staff.  While Congress has pointed to high salaries on Wall Street, Congressional wages continue to escalate along with the best benefit packages in the nation.

If Congress is going to hold the poor and elderly hostage, they also should forego their wages and the government should freeze their war chests.  If they don’t like it, perhaps they will go home and we can get something done.


The Republicans finally passed legislation called Cut, Cap and Balance.  This legislation was sent to the Senate.  Harry Reid described it as the worst piece of legislation that has ever been presented to the Senate and the bill was voted down immediately.

Republicans have walked away from the Biden talks when Cantor disappeared, the bi-partisan Gang of Six plan was rejected, Obama’s $4 trillion dollar long-time package and the McConnell Reid plan of last resort.

In essence, the Republicans are opposed to increasing the taxes on high-earning Americans.  They continually refer to these people as the job creators.  This argument does not hold water.  During President Bush’s presidency, the Bush tax cuts certainly did not create jobs.  When Obama took office, millions of Americans were losing their jobs every month.

Republicans support and, in fact, demand cuts to entitlements for the infirmed, the elderly and the poor.  Obama and the Democrats have pushed for a balanced give and take that would include Medicare, Medicaid and Social Security and either tax increases or plugging loopholes for wealthy individuals and corporations.

At this point, there are other complications crowding the scene.  The first is what effect these default talk may have on foreign investors.  The second complication is creating legislation that will appease the ratings agencies.  The third complication is that if a deal is not struck by Monday morning, the global markets will collapse.

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Emerging Market Currency Correlations Break Down

A picture is truly worth a thousand words. [That probably means I should stop writing lengthy blog posts and instead stick to posting charts and other graphics, but that’s a different story…] Take a look at the chart below, which shows a handful of emerging market (“EM”) currencies, all paired against the US dollar. At this time last year, you can see that all of the pairs were basically rising and falling in tandem. One year later, the disparity between the best and worst performers is already significant. In this post, I want to offer an explanation as to why this is the case, and what we can expect going forward.

In the immediate wake of the credit crisis, I think that investors were somewhat unwilling to make concentrated bets on specific market sectors and specific assets, as part of a new framework for managing risk. To the extent that they wanted exposure to emerging markets, then, they would achieve this through buying broad-based indexes and baskets of currencies. As a result of this indiscriminate investing, prices for emerging market stocks, bonds, currencies, and other assets all rose simultaneously, which rarely happens.

Around November of last year, that started to change. The currency wars were in full swing, inflation was rising, and there were doubts over whether EM central banks would have the stomach to tighten monetary policy, lest it increase the appreciation pressures on their respective currencies. EM stock and bond markets sputtered, and EM currencies dropped across the board. Shortly thereafter, I posted Emerging Market Currencies Still Have Room to Rise, and currencies resumed their upward march. It wasn’t until recently, however, that bond and stock prices followed suit.

What changed? In a nutshell, emerging market central banks have gotten serious about tackling inflation. That’s not to say that they raised interest rates and accepted currency appreciation as an inevitable byproduct. On the contrary, they have adopted so-called macroprudential measures (quickly becoming one of the buzzwords of 2011!), with the goal of heading off inflation without influencing broader economic growth. Most EM central banks have sought to achieve this by raising their required reserve ratios (see chart above), limiting the amount of money that banks can lend out. In this way, they sought to curtail access to credit and limit growth in the money supply without inviting a flood of yield-seeking investors from abroad. Other central banks have gone ahead and hiked interest rates (namely Brazil), but have used taxes and other types of capital controls to discourage speculators.

You can see from the chart of the JP Morgan Emerging Market Bond Index (EMBI+) below that EM bond markets have rallied, which is the opposite of what you would normally expect from a tightening of monetary policy. However, since EM central banks have thus far implemented tightening without directly influencing interest rates, bond yields haven’t risen as you might expect. In addition, whereas sovereign credit ratings are falling in the G7 as a result of weak fiscal and economic outlooks, ratings are actually being raised for the developing world. As a result, EM yields are falling, and the EMBI+ spread to US Treasury securities is currently under 3 percentage points.

The primary impetus for buying emerging markets continues to come from interest rate differentials. Given that interest rates remain low (on both an historical and inflation-adjusted basis), however, it’s unclear whether support for EM currencies will remain in place, or is even justified. Furthermore, I wonder if demand isn’t being driven more by dollar weakness than by EM strength. If you re-cast the chart above relative to the euro, the performance of EM currencies is much less impressive, and in some cases, negative. This trend is likely to continue, as Ben Bernanke’s recent press conference confirmed that the Fed isn’t really close to hiking interest rates.

Ultimately, the outlook for EM currencies is tied closely to the outlook for inflation. If raising the required reserve ratios is enough to head off inflation (and other forces, such as rising commodity prices, abate), then EM central banks can probably avoid raising interest rates. In that case, you can probably expect a correction in forex markets, which will be amplified by rate hikes in the G7. On the other hand, if inflation continues to rise, broad EM interest rate hikes will become necessary, and the floodgates will have been opened to carry traders.Either way, the gap between the high-yielding currencies and the low-yielding ones will continue to widen. In answering the question that I posed above, I expect that regardless of what happens, investors will only become more discriminate. EM central banks are diverging in their conduct of monetary policy, and it no longer makes sense to treat all EM currencies as one homogeneous unit.

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Where are Exchange Rates Headed? Look at the Data

At this point, it’s cliche to point to the so-called data deluge. While once there was too little data, now there is clearly too much, and that is no less true when it comes to data that is relevant to the forex markets. In theory, all data should be moving in the same direction. Or perhaps another way of expressing that idea would be to say that all data should tell a similar story, only from different angles. In reality, we know that’s not the case, and besides, one can usually engage in the reverse scientific method to find some data to support any hypothesis. If we are serious about finding the truth and not about proving a point, then, the question is: Which data should we be looking at?

I think the quarterly Bank of International Settlements (BIS) report is a good place to start. The report is not only a great-read for data junkies, but also represents a great snapshot of the current financial and economic state of the world. It’s all macro-level data, so there’s no question of topicality. (If anything, one could argue that the scope is too broad, since data is broken down no further than US, UK, EU, and Rest of World). The best part is that all of the raw data has already been organized and packaged, and the output is clearly presented and ready for interpretation.

Anyway, the stock market rally that began in 2010 has showed no signs of slowing down in 2011, with the US firmly leading the rest of the world. As is usually the case, this has corresponded with an outflow of cash from bond markets and a steady rise in long-term interest rates. However, emerging market equity and bond returns have started to flag, and as a result, the flow of capital into emerging markets has reversed after a record 2010. Without delving any deeper, the implication is clear: after 2+ years of weakness, developed world economies are now roaring back, while growth in emerging markets might be slowing.

Economic growth, combined with soaring commodities prices, is already producing inflation. (See my previous post for more on this subject). However, the markets expect that the ECB, BoE, and Fed (in that order) will all raise interest rates over the next two years. As a result, while investors expect inflation to rise over the next decade, they believe it will be contained by tighter monetary policy and moderate around 2-3% in industrialized countries.

The picture for emerging market economies is slightly less optimistic, however. If you accept the BIS’s use of China, India, and Brazil as representative of emerging markets as a whole, rising interest rates will help them avoid hyperinflation, but significant price inflation is still to be expected. I wonder then if the pickup in cross-border lending over this quarter won’t slow down due to expectations of diminishing real returns.

Any sudden optimism in the Dollar and Euro (and the Pound, to a lesser extent) must be tempered, however, by their serious fiscal problems and consequent volatility. As a result of the credit crisis (and pre-existing trends), government debt has risen substantially over the last three years, topping 100% of GDP for the US and 200% of GDP for Japan. Credit default swap rates (which represent the markets’ attempt to gauge the probability of default) have risen across the board. To date, gains have been highest for “fringe” countries, but regression analysis suggests that rates for pillar economies need to rise proportionately to account for the the bigger debt burden. According to a BIS analysis, US and UK banks are very exposed to Eurozone credit risk, which means a default by one of the PIGS would reverberate around the western world.

While I worry that such a basic analysis makes me appear shallow, I stand by this “20,000 foot” approach, with the caveat that it can only be used to make extremely general conclusions. (More specific conclusions naturally demand more specific data analysis!) They are that industrialized currencies (led by the Dollar and perhaps the Euro) might stage a comeback in 2011, due to stronger economic growth and higher interest rates. While GDP growth and interest rates will undoubtedly be higher in emerging markets, investors were extremely aggressive in pricing this in. An adjustment in theoretical models naturally demands a correction in actual emerging market exchange rates!

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Japanese Yen Due for a Correction in 2011

Based on every measure, the Japanese Yen was the world’s best performing major currency in 2010. It notched up gains every one of its 16 major counterparts, and was the only G4 currency to appreciate on a trade-weighted basis. Against the US Dollar, it rose 10%, and touched a 15-year high in the process. However, there is reason to believe that the Yen is now overvalued, and that 2011 will see it decline to more sustainable levels.

I am still somewhat baffled as to why the Yen has risen so inexorably. It is said that “Hindsight is 20/20,” but in this case the benefit of hindsight doesn’t really provide any additional clarity. Of course, there was the Eurozone Sovereign debt crisis and the consequent shift of funds into safe-haven currencies, but let’s not forget that the fiscal problems of Japan are even more pronounced than in the EU. Premiums on credit default swaps signal that the probability of a Japanese government default is twice as high as it is for the US, and there are rumors of a downgrade in its sovereign credit rating. As one commentator summarized, “Just how the Japanese have got away with running up a debt to GDP ratio of over 200% (higher than the PIIGS and the U.S.) is beyond me.” Of course, it helps that this debt is financed almost entirely by domestic savings and is consequently not vulnerable to the changing whims of foreigners, but even so!

Meanwhile, the opportunity cost of investing in Japan is high. While inflation is moot, equity returns are low and bond yields are even lower. “Japanese 10-year yields, the lowest among 32 bond markets tracked by Bloomberg data, will end 2011 at 1.24 percent from 1.19 percent today, according to a weighted forecast of economists surveyed by Bloomberg News.” Combined with low short-term rates, it would seem that the Japanese Yen would be the perfect candidate for a carry trade strategy.

Although foreigners remain net buyers of Japanese Yen, the current account/trade surplus is gradually narrowing, with the former falling 16% year-over-year and the latter dropping 46%. It seems that “consumers overseas increasingly spurn Japanese products in favor of lower-priced goods from South Korea and other nations.”

Even the Japanese seem to prefer other currencies. According to NIKKEI, “Japanese investors were net buyers of foreign mid- and long-term bonds to the tune of 21.94 trillion yen in 2010, the most since comparable data began being compiled in January 2005.” Japanese companies are also taking advantage of the expensive Yen and strong balance sheets to buy overseas assets. The Economist reports that, “Japanese companies are sitting on a hoard of cash totalling more than ¥202 trillion ($2.4 trillion)…Many companies have earmarked vast sums for acquisitions in 2011 and beyond.”

With GDP projected to fall to 1% in 2011, there would seem to be very little reason to continue buying the Yen. According to the most recent CFTC Commitment of Traders Report, speculators are building up massive short positions in the Yen. Meanwhile, the Central Bank of China is quietly paring down its Yen holdings. Even the Bank of Japan seems to have embraced this inevitability, as it is has already stopped intervening in forex markets on the Yen’s behalf.

According to a Bloomberg News Survey, “Japan’s currency will tumble almost 10 percent against the dollar this year.” Very few analysts think that the bottom will complete fall out from under the Yen, but the majority (myself included) expect a correction of some kind.

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EU Fragmented Before Summit

Recent developments by Moody’s Credit Rating Service have created alarm in the euro zone that will likely be the topic of conversation at the European Union Summit over the next two days.  Belgium is the latest country to suffer a credit rating paring at the hands of Moody’s, but the travails of Spain and Portugal present immediate and substantial problems.

Hardly a unified front, there exists deep differences between EU members on how to proceed.  With rioting in the streets of Greece and discord in Ireland’s parliament, tempers are running short throughout the zone. 

The two largest euro zone economies, France and Germany, are taking a “wait and see” approach to the debt crisis.  German Chancellor Angela Merkel has been especially critical of the European Union’s push to raise more money to fund the EU/IMF joint loan facility.

Merkel and EU Chairman, Jean-Claude Juncker, have clashed publicly over the concept of issuing euro zone bonds.  Merkel suggested that her talks with Juncker had ruled out the possibility but analysts suspect Junker may raise the issue in the upcoming, year-end summit.

Meanwhile, Junker issued a warning to Spain and Portugal saying, “They would do well… to present structural reforms to be introduced beyond the plans of consolidation already announced.”  Both Spain and Portugal have been subject to increased pressure in bond markets.

Spain and Portugal  

The yields on Spanish 10-year bonds rose sharply on Wednesday.  The euro fell against the dollar as European equities also turned down.

Portugal announced intentions to cut through the red tape and enable economic growth.  The country also will adopt quarterly fiscal goals to go along with its planned austerity cuts.

On Wednesday, Portugal sold 500 million euros of three-month treasury bills at a punitive rate of 3.4 percent.  Last month the rate for the same volume was 1.8 percent.

Cash strapped Spain has 275 billion euros of sovereign debt and bank debt due to expire in 2011.  The country has vowed to implement huge spending cuts that will virtually affect every aspect of the country. 

The Moody’s warning to Spain specifically mentioned the high cost of debt servicing and the state of the national and regional banks as the basis for a possible downgrade, which seems imminent.  Moody’s fell short of suggesting that a EU bailout was necessary.

Arnaud Poutier, deputy head of IG Markets France, issued the following summary, “Europe remains very fragile.  Everyone sees a major crisis in the first few months of 2011 that would coincide with Spain’s refinancing operations.”


Ireland’s beleaguered Prime Minister Brian Cowan gained support in Parliament for the 85 billion euro bailout from the IMF/EU fund.  The first disbursement is expected early next week.

Approval of the bailout and the strict austerity cuts imposed on the country have created waves of opposition.  Cowan is expected to be voted out of office in early elections next year. 

The opposition has said there is no moral or legal obligation to honor Irish bank obligations to shareholders.  The opposition party has said they will attempt to renegotiate the IMF/EU loans.

EU Discord

On Tuesday, Standard and Poor’s lowered the rating of Belgium’s sovereign debt.  The credit agency warned of another downgrade in six months.  Not surprisingly, Belgium Prime Minister, Didier Reynders, pointed to a doubling of the EU’s 440 billion euro portion of the loan facility.

Most of the euro zone members do not expect any decision at this time.  Merkel has said that only 10 percent of the fund has been used to date and that an increase in the member contributions would lead to unrest in the global currency markets.

However, European Central Bank President, Jean-Claude Trichet is expected to support an increase in the fund.  The ECB has come under pressure to increase its bond-buying as the zone peripheral countries struggle to manage their debt.

On Thursday, Switzerland, a leading trader in the zone, held interest rates at current levels in efforts to stabilize euro zone economies.  Despite the euro’s instability, Switzerland continues to prosper.

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“Risk-On, Risk-Off”

It sounds like a play on words, based on the Karate Kid refrain, Wax-On Wax Off, and for all I know it was. Still, I rather like this characterization – coined by a research team at HSBC – of the markets current performance. Moreover, you’ll notice from the placement of that apostrophe that I’m not just talking about forex markets, but about the financial markets in general.

What we mean is that when risk appetite is high, credit markets and equities and high-yielding currencies tend to rally together. When risk appetite fades, “those assets fall and government bonds and safe-haven currencies, including the U.S. dollar, the Swiss franc and, in particular, the Japanese yen rally.” Data from Bloomberg News confirms this phenomenon: “The 120-day negative correlation between Intercontinental Exchange Inc.’s Dollar Index and the Standard & Poor’s 500 Index was at 42.4 percent today, and has been mostly above 40 percent since June 2009.”

Skeptics counter that this correlation is tautological. Anyone can point to a stock market rally and declare that “Risk is Back On.” In addition, it’s not wholly unsurprising that there are strong correlations between low-risk currencies and low-risk assets, and between high-risk currencies and high-risk assets. According to HSBC, however, this time is different.

US Dollar Versus S&P

For example, models suggest that the recent decline in volatility should have caused these relationships to break down. That they defied predictions and remained strong suggests that we have witnessed a significant paradigm shift. In the past, “Rising correlations are also tied to weak macroeconomic conditions.” At the moment, this could hardly be more true, with global economic growth flagging.

Statisticians love to teach the dictum, Correlation does not imply causation. Nonetheless, I think that in this case, I’d wager to say that the equity and credit/bond markets are driving forex, rather than the other way around. Consider as evidence that, “[Retail] Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year,” and shifted this capital into bonds. While this wouldn’t in itself be enough to drive the Dollar higher, it epitomizes the steady shifts that have been taking place in capital markets for nearly a year, broken only by the S&P/Euro rally in the spring (which now appears to have been an aberration).
Investors Shift Money from Stocks to Bonds
In fact, these shifts are once again creating shortages of Dollars: “This week, two banks bid at the European Central Bank’s weekly dollar liquidity providing auction – the first time there have been any bids since May – suggesting that they could not raise dollars in the market.” This suggests that demand for the Dollar could continue to grow.

Some analysts have suggested that the low-yielding US Dollar is already on its way to becoming a funding currency for carry traders, but I think this is wishful thinking. The HSBC report supports this conclusion, “A weakening of the ‘risk on-risk off’ paradigm is likely only once macro conditions are improved in a sustainable way…Currency performance will likely be tied to the ebb and flow of the perception of risk for some months to come.” In short, until there is solid proof that the global economy has emerged from recession (even if ironically it is the US which is leading the pack downward), the Dollar will probably remain strong.

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