What We Missed: Japanese Liquidity Flows
John Mauldin's Outside the Box

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About a month or so back I wrote about some of my thoughts regarding interest rates and monetary policy being affected by both velocity and the money supply (see When Will the Fed Stop?). In my letter, I highlighted some exceptional research performed by my good friends at GaveKal. Well they have done it again, this time turning their attention towards Japan and the global economy.

Founded in 1999 by Charles and Louis-Vincent Gave and Anatole Kaletsky, GaveKal is a global investment research and management firm that provides an array of financial services worldwide. They are best known for their study of monetary policy, fiscal policies, secular trends, technical analysis and asset class valuations which they use to form a unique perspective on the relationship between the financial markets and the global economy.

In "What We Missed: Japanese Liquidity Flows," we are presented with an in-depth analysis of the role of Japan amongst the growing interconnectedness of today's financial markets. Both the past and current decisions of Japan's policy makers have had a profound effect on the global economies that has produced a new metric which they call the "international yield curve." I think that you will find this study to be as equally intriguing as I have. It is, indeed, outside of the box thinking.

John Mauldin, editor


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What We Missed: Japanese Liquidity Flows

With economic activity seemingly still powering ahead, with large caps still underperforming small caps everywhere, with emerging markets still outperforming the more developed markets, with commodities still outperforming almost everything else out there... we have clearly missed a boat in recent months. Indeed, while we had argued in all of our research that the structure of our economies was sound, we have also highlighted our fears of a potential cyclical slowdown and the effects that a tightening liquidity environment would have on the frothier asset classes. On this last point, we have been clearly wrong and have tried to find out, why despite the withdrawing of liquidity by central banks from the system, liquidity has remained so ample.

1- A Brief Historical Reminder

A few years ago, as Japan remained stuck in its deflationary bust, most cognoscenti were happy to pronounce that Japan had become "irrelevant"; and sure enough, most investors stopped paying attention to what Japanese policy makers were really up to. Meanwhile, faced with a collapse in the domestic velocity of money, Japan's policy makers were about to adopt a set of policy which would influence asset prices all over the world and whose repercussions are still felt today. The reason behind the collapse in the velocity of money was easy enough to diagnose: Japan's commercial banks were, by and large, bankrupt. This left Japan's policy makers with two options:

A) Nationalize and recapitalize the bankrupt commercial banks (a course of action which most policy makers felt was too politically contentious) or

B) Flood the system with high powered money, so that the collapse in V would be compensated by the rise in M so that P*Q (i.e.: nominal GDP) could stabilize (as per Irving Fisher's MV=PQ). And the policy of quantitative easing (QE) was born. This policy of QE came on top of other policies already implemented, namely the zero interest rate policy (ZIRP) and a policy of control of the exchange rate in a band of ¥105-¥120 against the US$. And together, these policies would have a massive impact on global financial markets.

2- Japan Dumps Money into the System - QE

One of the trademarks of perma-bears is to blame all the World's ills on an hyper- active Fed whose policy shifts endanger the state of our economies and the value of financial assets. But is this a fair indictment? Judging Fed policy by the growth rate of the US monetary base (see chart), we find that the US monetary base has been growing fairly steadily and in line with US GDP growth. In fact, if one wants to blame a central bank for volatility in global monetary aggregates, one should instead turn to Japan. The chart shows the US monetary base, the Japanese monetary base- in dollars- and the sum of the two (also in dollars). What emerges from this graph is very simple: all the volatility in the US + Japanese base aggregate has come from the Japanese part of the component. The volatility in global M has in the past thirty years come from Japan.

Looking at the past thirty five years, we find that the Japanese monetary base has been allowed to double over short periods (i.e.: less than three years) three times. Each time, it led to massive bull markets (real estate, share prices, commodities, gold, etc...), followed, some time after the expansion of Japan's money supply was over, by a serious market downturn. Will this time prove any different? So far, it has!

Another interesting fact drawn from the above chart is that, following the large 2001-2004 expansion in the Japanese monetary base, the Japanese monetary base is now larger than the US'. That is quite impressive for an economy less than half the size.

3- Beyond QE, ZIRP and Exchange Rate Stability

The most recent increase in money supply (policy of quantitative easing) was preceded by two others policies:

1. Short rates were been maintained at, or close, to zero since 1996.

2. A deliberate attempt was introduced to maintain the Yen spot exchange rate more or less stable around the US dollar in a band of ¥105-120/US$.

The combination of QE, ZIRP, and FX stability then almost guaranteed that a lot of the excess liquidity created by the BOJ would be exported. Look at the following chart: from 1988 to 1995, the forward market (black line) more or less followed the red line (spot rate). In simple words, the exchange rate's best forecaster was the forward market. But starting in 1995, the relationship broke down. Basically, anyone who borrowed Yen to invest in dollars, or, in other words, paid the Yen interest rates and received the US$ interest rates, would today be up +50%, despite the fact the Yen spot rate is roughly were it was 11 years ago.

Anyone who had borrowed Yens to invest outside of the Yen area would have had an excess return every four years equivalent to the bar chart below. On average, returns would have been higher by some 16 % over any four year periods. And the last time one lost money being short the Yen was in 1999.

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4- The Yen Carry Trade & the New Yield Curve

Needless to say, these excess returns were identified by investors all over the world. And first and foremost in Japan. Indeed, if one is guaranteed by one's own central bank an extra return of 4% a year for investing abroad, then, sure enough, one tends to invest abroad with gusto! How does this policy translate in numbers? Firstly, to prevent the Yen from rising, Japan's central bank reserves rose from US$180 billions to US$ 820 billions in ten years-this was the cost of the guarantee. In parallel, reassured by the stubbornness of the BOJ in preventing the yen from rising, Japanese net private sector assets invested abroad went from 0 in 1995 (an abnormally low number linked to the liquidation of assets after Kobe earthquake) to US$1 trillion now. The combination of QE, ZIRP and Exchange rate stability has thus led to US$

1.8 trillion worth of Japanese capital appearing abroad in a little less than ten years. To put this into perspective, this amount is roughly equal to 15% of US GDP or 3% of the total value of US assets today. And of course, the Japanese investors were not the only ones to jump on the opportunity of cheap capital. A number of people around the world started to use the Yen as a cheap source of funding. But on this front, getting hard data on what is essentially the world's short position on the Yen is impossible for a simple reason: borrowing can conceptually take place in the national currency of the borrower, on top of which currency hedges can easily be added to boost returns. And forex markets are far too big, and far too diverse to be monitored properly.

We have, however, plenty of anecdotal evidence of such a development: for example, in the second half of the year, when the Japanese market went up, the Yen went down, and vice versa (a reverse of previous historical patterns and a potential sign that foreigners were borrowing Yen to invest in Japan). This inverted relationship between the Yen and asset prices also became visible with gold, some emerging markets, etc...).

The growing ease of financing in cheap interest rates, wherever they may lay (today in Japan, tomorrow in Europe?) raises an important question: could the low Japanese interest rates and easy Japanese monetary policy be undermining the tightening of monetary policy undertaken by the Fed, the BoE, the ECB...? If the Yen is now a privileged source of funding, and if one is reasonably certain that the exchange rate yen dollar will not move up by more than 5% a year, the yield curve that one should be using as a leading indicator for the US and global economy should then not be American long rates minus American short rates, but American long rates minus Japanese short rates.

Let us have a look at this new and improved version of the yield curve. Witness how it has led, and continues to lead, the world economy.

So maybe Mr. Bernanke is right. The yield curve as most people understand it does not present much information anymore. What matters instead is the international yield curve. Thanks to the globalization of the financial revolution, only financial actors with no access to foreign funding (i.e.: low end of housing sector) are impacted by the rise in short rates. Meanwhile, companies, financiers, high net worth individuals... are able to finance themselves at the cheap rate (which, today, is in Yen) and continue to prosper on the carry trade...

And frankly, this is what has happened in recent months: under pressure from rising US interest rates, US housing has been slowing. A slowdown which, we had been forewarned by perma-bears (for years!), would lead to a sharp slowdown in both US and global activity, hereby triggering an ice age, etc... The ironic thing is that, since October, US housing has been slowing... and yet global growth has continued to boom!

5- So Where Does That Leave Us?

The Fed has recently been making noise implying that its tightening job is nearly over. With the lags inherent in monetary policy, we are told, a slowdown should soon hit the US economy, followed shortly after by an abatement in US inflationary pressures. This all sounds great and, to a large extent, the markets have been busy rallying on the possibility of such a "goldilocks scenario". But there is, however, one problem with the Fed's scenario: as we highlighted last week in Disturbing Inflation Data, none of the recently published data seems to show that the Fed's scenario is coming to pass. On the contrary: prices are still rising, and growth is still accelerating. Given the ideas developed above, one could thus start to question whether the rise in US short rates will prove enough to impact global economic activity and tame the animal spirits currently running wild (see The Dash to Trash).

And this leaves us at an important crossroads: does the Fed assume, on the one hand, that its academic models are correct and start to sit back (and hereby run the risk of falling behind), or does it continue to tighten? The risks, we believe, are very asymmetrical. Indeed, if the Fed overshoots, it can rapidly cut interest rates and throw money back into the system. But what if the Fed falls behind the curve? Then the price of regaining the lost credibility could prove very costly.

There is, of course, another course of action for policymakers, one that we touched upon a few weeks ago in The BoJ in the Line of Fire. Very simply put, since the distortion in the global markets comes from the fact that borrowing Yen is still perceived as a low risk/low cost proposition, should we not expect US and European policy makers to put pressure on the BoJ to end this anomaly?

In fact, is this not what we witnessed this past weekend at the G7 meeting and isn't the sharp rise in the Yen of the past 72 hours a sign that the investment environment might be changing?

6- Conclusion

The leverage in the system has continued to grow in the face of rising interest rates from most central banks. This is a development that we did not expect and which took us by surprise. As a result, the overall leverage in the system today is probably more prevalent, and widespread than most realize (a quick example: everyone bangs on about the impressive growth in China's reserves without stopping to wonder how China's reserves, in the past four years, have managed to outgrow China's trade surplus and FDI inflows by anywhere between US$60bn and US$100bn per annum).

As illustrated by the increase in foreign assets held by Japanese, and by the impressive increase in the Japanese monetary base (now bigger than the US monetary base), a fair amount of the leverage has taken place in Yen. This is a consequence of the fact that, thanks to the globalization of the financial revolution, borrowing in Yen is still too easy. At least, it is still too easy if the World's central banks are serious in trying to tame the growing inflationary pressures.

So we reiterate what we wrote in The BoJ in the Line of Fire: if the central banks are serious about taming the global inflationary pressures, then the tightening now has to happen in Japan. In a sense, this tightening has already begun: the policy of QE has been abandoned and the growth rate of the Japanese monetary base is now negative.

Will this prove enough? Or will we need to see either a rise in the Yen or an end of ZIRP? Could the rise in the Yen already be happening? Could interest rates in Japan rise by the summer (hereby allowing Koizumi to declare victory against deflation before retiring in the Autumn).

If the ZIRP ends, and/or if the Yen starts to rise, could some of the US$1.8 trillion exported by Japan in the past decade come home, either to be reimbursed, or to be invested in JGBs? What effect would this have on other bond markets since most of the capital exported by Japan went into UST, Bunds, Gilts etc... (see Of Bonds and Zombies)? Would the sustained rise in the Yen called for by Mr. Breton (the French finance minister) on three separate occasions in the past week not lead to a massive destruction of global credit?

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Answering most of the questions above, we find that, in such an environment, the least risky asset would be Japanese Yen in cash, followed closely by Japanese bonds, other Asian currencies and Asian government bonds in countries such as Singapore, Thailand, Malaysia... More importantly the odds of this scenario are, we believe, not negligible. In 1974 and 1987, the end of the Japanese monetary expansion and the return to the norm led to a sharp increase in market volatility. Should we expect the same thing again? We reiterate our recommendation to buy Yen calls to hedge "at risk" positions in portfolios.


You're always watching the Japanese markets analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 05-08-2006 9:47 PM by John Mauldin