I know that Friday’s market action was probably a little exaggerated due to the fact that it was month end (and also year end for many financial institutions). But I still found the moves frightening. I know that my concerns are definitely in the minority as most people believe that stock market rallies are much like being too thin or too rich – you can never be too much of either. The stock market rocketing higher can only be a good thing – regardless of the underlying reasons for the rally.
Although I understand why people would feel that way, I am scared that the drivers behind this rise are much more precarious than the public understands.
I believe that the recent the Japanese GPIF’s (Government Pension Investment Fund) decision to dramatically increase their stock market allocation, along with the next day follow up announcement from the Bank of Japan to increase their QE program, are the main driving factors of this latest global stock market rally.
Although I do not begrudge the GPIF asset shift, the Bank of Japan timing and aggressiveness of the new stimulus, has introduced much more risk than most realize. The Japanese are playing with forces whose power they underestimate.
The Bank of Japan was already on a schedule to increase their balance sheet by 60 trillion Yen in the coming year. But Friday’s announcement to increase it to 80 trillion Yen caught the market off guard. It is not as if their balance sheet has been shrinking like the ECB’s. The BoJ has actually been the most aggressive Central Bank out there over the past couple of years.
Have a look at the Bank of Japan’s total balance sheet size over the past 15 years.
The explosion higher since the introduction of Abeconomics is unprecedented by a major Central Bank. The fact that they are now increasing it is even more ballsy.
It is not as if they are having any problems creating inflation. Have a look at this chart of their CPI.
I know that it has been boosted by the recent sales tax increase, but inflation is inflation. Prices are going up in Japan.
What is most interesting is that this increase in the QE program comes at a time when their 10 year real rate is already at record breaking negative levels.
Increasing the Quantitative Easing program (and also shifting their mix to even riskier securities because they are running out of JGBs to monetize) is akin to a formula one driver barely staying on the road during a turn, but deciding that accelerating even faster into the next one is right play.
This is a bold gambit that represents a de facto devaluation of their currency. The Yen sold off hard on Friday, and well it probably should.
The next era
The more I think about this latest BoJ move, the more convinced I become of the possibility that this has ushered in the next chapter in the global economy’s massive problem of too much indebtedness.
I know we have all become somewhat numb to these monster numbers that Central Banks toss around. We quickly scurry ahead of the Central Bank, trying to front run the buying of their next purchase, without enough thought given to the long term implications of these moves.
I am aware that the pundits who were claiming that the US QE programs would cause inflation have been thoroughly discredited. These days you get a better reception admitting you have ebola than trying to argue that massive expansion of a Central Bank’s balance sheet causes inflation.
Yet I think we have had inflation – it’s just that the inflation has been concentrated in financial assets.
I have already confessed that I thoroughly misjudged the Fed’s ability to inflate only the financial aspect of the US economy. I thought the Fed might be able to raise the price of stocks, but only if all other nominal asset prices came along for a ride. That proved to be dead wrong.
Over the past two years, the Fed has inflated financial asset prices, all the while commodities and other hard assets have collapsed. The US economy is the best performing major economy in the world. All the worry warts that were warning of the dangers of the Fed’s massive balance sheet look like chicken littles (me included).
And now, the Japanese seem to be following in the Fed’s footsteps with even bolder balance sheet expansions of their own. And even more interesting, the market is applauding their moves – in fact, they are giving the Japanese standing ovations.
Amongst economists, the increasing belief is that QE programs have limited effect on inflation, with all sorts of other wonderful benefits.
When the Fed first embarked on their massive QE program, Europe (and Germany in particular) viewed it as reckless and the wrong course of action. They espoused austerity and economic reforms. Five years later, the European economy is stuck in the mud with an increasing chance of being completely buried, while the US economy is rocketing higher.
The debate seems to have been settled (at least in the minds of most economists) – and the US decision to inflate seems to have won the day. There are very few (especially amongst those who don’t speak German) who would still argue that the European course of action resulted in a better economic outcome than the American decision.
Which creates an interesting new dynamic. QE seems to have no downside. And yet the failure to expand your balance sheet (like the Europeans) has a real economic cost.
The Japanese have figured this out. How long before all the other Central Banks do the same? Have we entered into a new era where QE becomes the norm? After all, there is no inflation to speak of, and if you don’t inflate you end up like the Europeans, what’s the point of fighting it?
I am worried that we have set upon a new stage of competitive devaluation via QE.
What if it gets out of control?
What worries me is the possibility of this monetary expansion catching fire. When the US embarked on QE3 inflation was flat lining below target. The Japanese are expanding their program with inflation running above target and their currency already declining.
This could spin out of control really fast. Way faster than most market participants realize.
My guess is that at some point the Yen will be going down faster than the Japanese ever wished.
However, in the mean time, stocks are running like they stole something. The Bank of Japan has told you that not only are they increasing the absolute amount of their quantitative easing, but they are going to buy more equities because they are running out of government bonds. Stop and think about that for a moment… The absurdity of a Central Bank monetizing equities is almost beyond belief. It distorts all the pricing signals and exponentially increases the macro risk for private investors. But it is what it is. No sense in getting all indignant about it. It will end badly, but in the mean time there is no reason to step in front of the freight train. The buying could very well feed on itself and create the biggest bubble we have ever seen. I do not rule that out. Central Banks trading S&P futures was something I would never have guessed in a million years, but here we are…
Headed to the sidelines
Thursday, with the GPIF announcement I flattened many of my positions. It was a little bit of a game changer for me, and although I wasn’t smart enough to take advantage of the ensuing moves, I was at least not so dumb to keep fighting (most of them).
Over the week-end, as I reflected on the past two days, I am struck by the fact that this Bank of Japan move might be the start of some really big moves. The global economy was slipping into a mini-deflationary slump, and while many market participants were looking for the Federal Reserve to provide the needed liquidity, the Bank of Japan stepped up to the plate instead.
Although it feels like the Yen has gone a long way over the past couple of years since the introduction of Abeconomics, step back and look at the really long term chart.
We might be simply getting started.
Be long FX vol!
Given the massive moves in the FX market over the past few days you would think that FX volatility would be going through the roof. And although it has indeed risen, G7 forex vol is still remarkably low.
I think that the volatility in the foreign exchange market will only continue to rise. This move by the BoJ is just the start of a series of new initiatives from various other countries to attempt to inflate their way out of the problem.
Going forward, I am going to execute all of my FX directional trades through options until volatility is bid at levels appropriate for the increased level of risk.
Although right now precious metals look like death and everyone is busy telling you how gold is headed to $1,120 or $1,000 or even $700 – be extremely careful. I will admit we did break some really big support on Friday. We also failed to bounce after lunch like I expected. But given the bearishness out there, it wouldn’t surprise me at all if this breakdown ends up being a bear trap.
I am not suggesting you buy it yet. But if it somehow does manage to climb back into the range, there will be a lot of weak shorts that will have gotten caught.
Wait for it to climb back up. No sense being a hero. But if it can manage to get above $1,180 and hold, then at certain point it will make sense to play for a squeeze higher.