The Globalisation of Finance
Below is an extract from a commentary originally posted at www.speculative-investor.com on 10th December 2006.
The Liquidity Boom Continues
The way the financial world used to work, short-term interest rates in the US being higher than long-term interest rates in the US would preclude any possibility of Treasury Bond prices being boosted by carry trades (borrowing short-term money in order to invest in longer-term debt, thus earning the "carry", or interest rate spread, between the two types of debt). But that was then, this is now. The way things work today, if short-term rates in the US are prohibitively high then carry-traders can simply do most of their borrowing in Europe. And if short-term rates in Europe are too high it's still not a problem because they can do most of their borrowing in Japan. After all, despite some mild 'jawboning' to the contrary the Bank of Japan seems intent on keeping short-term interest rates near zero and accommodating all demand for short-term money indefinitely.
Furthermore, if the 4% spread between short-term Japanese interest rates and US T-Bond yields isn't sufficiently enticing, even after taking into account that the annualised return on the aforementioned Japan-US spread trade could be boosted to 40% using routine 10:1 leverage, no problem again; just borrow in Japan and use the proceeds to 'invest' in Brazilian or Turkish bonds, remembering, of course, to use various derivatives to hedge away any currency or credit risk. In fact, although today's ridiculously low credit spreads wouldn't appear to provide adequate compensation for the additional risk it might also make sense for a speculator to borrow at the comparatively high rate of 5% in the US in order to finance the purchase of, say, Indonesian Government bonds given that any risk could be passed on to counter-parties at the cost of a relatively small insurance premium.
The point is, the supply of 'hot money' (money that can be shifted around rapidly in response to changes in expected returns) now seems to be endless because if monetary conditions start to get tighter in one part of the world then the speculative community can always find a source of low-cost financing somewhere else. And the Bank of Japan (BOJ), with its zero or near-zero interest rates, effectively underwrites the whole process. This is why the financial markets experienced some palpitations during the first half of this year when the BOJ soaked-up a lot of liquidity and made noises about commencing a rate-hiking program, and why the speculative juices resumed their flow as soon as the BOJ backed away from its planned monetary tightening. It is also why an official US recession might not follow this year's inversion of the US yield curve. During past cycles an inverted yield curve has meant that financial market liquidity was about to contract in a big way, but that's not necessarily the case today.
What we have, right now, is the outward appearance of monetary conditions in the US and some other G7 economies that would, under normal circumstances, bring about substantial weakness in equities and/or commodities and/or bonds, and yet all of these major asset classes are doing well. It almost seems as if it doesn't matter what the US Fed or the ECB or the Bank of England or the Reserve Bank of Australia do, there will be plenty of liquidity as long as the BOJ continues to price short-term credit at bargain-basement levels and leaves its borrowing window open to all comers.
We can't confidently predict how long the liquidity boom will continue other than we are sure it won't continue beyond the point where the BOJ gets serious about tightening its monetary policy, although it could certainly end well before that point. If forced to make a guess we'd say that things will come to a head during the first quarter of next year, but there's really no need to guess because when a major liquidity turning point arrives its footprints should be evident in a) the relative performances of gold and base metals (gold will become relatively strong), b) the yield-spread (short-term interest rates will begin to trend lower relative to long-term interest rates), c) the relative performances of high-risk debt and Treasury debt (high-risk debt will become relatively weak), and d) the relative performances of emerging market equities and US equities (emerging market equities will become relatively weak).
In the mean time we'll remain skeptical about the sustainability of the latest in a long line of "new eras" while steering clear of any bearish bets.
The Yen: a casualty of the liquidity boom
We have said in the past that we are long-term bullish on the Yen, meaning that over the next 5 years we expect the Yen to lose its purchasing power at a slower rate and to fall by less, relative to gold, than most other fiat currencies (the strongest paper currency is the one that weakens at the slowest pace). This view was based on our beliefs that a secular bear market in Japanese equities ended in 2003 and that Yen inflation would remain relatively low.
Japanese monetary authorities' insistence on keeping short-term Yen interest rates pegged near zero is, however, forcing us to re-think. There are many things that central banks cannot do, but one thing they are all extremely good at is currency de-valuation. When a central bank seems determined to follow a policy that will not only cause its currency to weaken relative to gold but also cause it to weaken relative to other paper, it makes no sense to bet against it.
Thanks to Japan's "weak Yen" policy the Yen is in the bottom third of its 3-year range while the US dollar's other major competitors are in the top third of their 3-year ranges. Furthermore and with reference to the following monthly chart, it looks like Yen futures are going to test the bottom of their 3-year range (80) at some point over the coming few months. If this happens it will probably be worth going 'long' the Yen for a trade, but we are going to step away from our long-term bullish outlook on the Japanese currency until we see some evidence that the BOJ is going to allow interest rates to adjust to more normal levels.