Why the Current Strength of US Bonds Will Be Short-Lived

03/16/11 Salta, Argentina – Stocks down…gold down…bond yields flattened…world markets roiled…

And yet, all this pales in comparison to the very real world horror going on right now in a small group of islands in the Pacific Ocean. Tens of thousands of people in one of the world’s most developed economies are without access to clean drinking water tonight and without power in sub zero temperatures. Families huddle together, not knowing if or when the next disaster might be visited upon them.

Millions more around the world watch on with sorrow, horror, perhaps even guilt, at what they see unfolding across Japan. Some will point to the failings of man…others to the mystery of a god…and others still will simply sit and scratch their heads…

“What’s the reason?”…“What does it mean?”…“Why there and why now?”

Before we begin to assess the financial implications of Japan’s 9.0 monster earthquake, we first offer our heartfelt condolences to those who suffered this most recent expression of nature’s blind wrath.

Callous as it must surely seem, sometimes the only thing to do in these situations is to keep on keeping on. Carpenters keep building…engineers keep designing…scientists keep searching for cures…doctors keep administering them…

And reckoners? Well, those of us with little better to offer than our thoughts and words…well, we keep on reckoning…crude and searching as our words must at this time appear…

So we return to our post; to stocks, gold and bonds. Where to from here?

To be frank, it’s probably too early to comprehend the extent of the damage wrought by the quake in Japan with any measure of certainty. We’ll have to see what comes of this in the weeks and months ahead.

However, it’s probably not too early to begin trying to understand what Japan’s crisis might mean for long-term US bond yields. Dan Denning, the Daily Reckoning’s “Man Down Under,” pondered this very question in his Aussie DR musing this morning.

“The Japanese are one of the largest holders of US Treasuries and continue to buy them,” observed Dan, before adding, “That capital might be put to a lot better use in the coming years rebuilding from the quake and tsunami damage.”

Dan raises a very important point. We’re seeing a flight to “safety” right now, no question. US Treasuries rallied yesterday, more or less in sync with the horrific images coming from the Fukushima and Sendai newsreels. The yield on the benchmark 10-year note briefly touched 3.2%, its lowest level this year, reflecting the “safe haven” appeal of bonds. (Bond prices and yields move in opposite directions.)

But what happens when the dust settles a little and Uncle Sam wakes up to find one of the go-to buyers for his ever-accumulating debt has put in a no-show? What happens, in other words, when the second largest holder of US debt discovers he has his own, 9.0 earthquake-sized problem to deal with? According to data released by the Treasury on Tuesday, Japan held $886 billion worth of Treasuries at the end of January, the second largest foreign holder behind China. That’s a big gap to fill…even by fractions.

“Of course in the short term, the ‘risk off’ trade is bullish for US bonds and the US dollar,” continues Dan. “People are cashing in their chips and storing up their cash. But longer term, the US may find it a lot harder to fund deficits without the help of at least one major foreign buyer. This will put more pressure on the Fed to monetize debt right away.”

What then will the Fed do? Well, exactly what the Fed always does, of course; precisely that which it shouldn’t. The Fed will, as Dan points out, continue its attempt to “monetize” (read: print) away its debt.

It goes without saying that this strategy is a complete non-starter, as far as any measure of logic is concerned. Academic types like to argue that a weaker currency and/or more liquidity are great ways to jump-start flailing economies. They argue that a flaccid currency gives exporters an edge abroad and that a blast of paper money stimulates spending back home. In reality, all this does is perpetuate a weakening confidence in that particular currency as a store of value and, thereby, discourage those with whom the offending government might wish to trade from wanting to accumulating them. Who, after all, wants a vault full of Zimbabwean dollars, Hungarian pengos or US Continentals?

And lo! Always on the ball, Addison writes in this morning’s edition of The 5, “Easy money is already having its affect in the US. Wholesale prices, which trotted upward in December and January, reached a full gallop in February.”

The upward-trot-to-record-gallop to which Mr. Wiggin is referring is, at least according to a story we saw coming across the wires this morning, the steepest rise in food prices in 36 years.

Continues Addison, “The producer price index (PPI) rose 1.6%. Even after the usual statistical sleight of hand applied by the Bureau of Labor Statistics, the number is more than double what the Street expected. Annualized, it’s 19.2%.

“That’s for finished goods. If you move further back in the production chain, prices for crude goods rose 3.4% last month. And February was no fluke. PPI for crude goods has risen 20.7% over the last six months.

Of course, the Fed’s own measure of inflation – that nebulous, periodically redefined, terminally elastic non-statistic – remains, according to the Fed itself, “subdued.”

Hooray!

Alas, this news comes to us from an institution that actually admits – with a straight and serious face, no less – that it actively targets a 2% erosion in the value of your money per year. The Feds guarantee, in other words, that they will steal, or do their best to steal, via inflation, 2% of anything you earn or own every year for the rest of your life…or for its. That is its stated “sweet spot.”

It’s enough to make one think of the term “greed” in a whole new light…

Joel Bowman
for The Daily Reckoning

Joel Bowman is managing editor of The Daily Reckoning. After completing his degree in media communications and journalism in his home country of Australia, Joel moved to Baltimore to join the Agora Financial team. His keen interest in travel and macroeconomics first took him to New York where he regularly reported from Wall Street, and he now writes from and lives all over the world.

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Japanese Yen Strength to Be Short-Lived?

03/14/11 St. Louis, Missouri – The currency markets did an abrupt shift on Friday, as the dollar turned negative for the first time in a week, giving back most of the gains it had slowly accumulated since last Monday.

But the dominant story in the markets remained the Japanese earthquake and tsunami. My thoughts and prayers certainly go out to the people of Japan. The pictures of the wall of water and debris rolling across the landscape is shocking. And the destruction may not be over, as a couple of nuclear plants are still not under control. As I wrote Friday, the disaster has boosted the Japanese yen (JPY) to trade near its record high. The highest I have seen the yen trade was back in April of ’95 when I worked at Mark Twain Bank and saw the yen trade at 79.75 per dollar. Interestingly, this followed the 6.9 magnitude earthquake that rocked Kobe, Japan in 1995. I heard a couple of reporters using the Kobe earthquake as a basis to predict a sharp appreciation of the yen in the coming months; and I can see why they would make the comparison. The Japanese yen shot up over 20% in 1995 during the three months following the Kobe earthquake, and Friday we saw the yen move up about 1.25% versus the US dollar.

But I still think this appreciation of the yen will be short-lived. Companies and individuals immediately started to repatriate funds back into Japan to help with the rebuilding efforts. This helped push the yen higher on Friday, and we will probably see further appreciation of the yen in the coming days. But the 20% increase we saw in 1995 wasn’t all due to the Kobe quake. Most of this appreciation occurred after Nick Leeson took down Barings Bank. Leeson was a rogue trader who piled up enough leveraged bets to bring down London’s oldest merchant bank. This sent a major shock through the financial markets, and investors rushed to the Japanese yen, which was seen as safe haven.

But today is different. Japan currently has world’s largest public debt burdens, and will undoubtedly need to borrow even more yen in order to rebuild. And the Japanese economy, which looked as if it was just starting to grow, will certainly see a slowdown. Toyota, Sony, Honda, and Mitsubishi have all announced plant shutdowns, with many warning these shutdowns could last a while. These companies have immediately repatriated funds back into the yen, but will probably have to issue additional debt in order to complete the rebuilding efforts. So the markets are going to be swamped with Japanese debt offers in the near future. All of the yen-denominated bonds will ultimately prove to push the value of the yen lower. It gets back to the old fundamental rule of supply and demand. The government and corporations are generating yen by the sale of these bonds, dramatically increasing the amount of Japanese yen trading in the currency markets. With a supply of yen higher, and demand for the low-yielding yen decreasing, the value of the yen will fall.

So in my opinion, investors in the Japanese yen should look to exit over the next few days/weeks. The gains we are seeing right now won’t last. Investors looking to move out of the yen but wanting to keep an Asian exposure should take a look at the Singapore dollar. The Monetary Authority of Singapore will likely allow further currency appreciation in order to cool inflation. The Singapore dollar (SGD) looks to be a good alternative to either the Japanese yen or the Chinese renminbi (CNY) whose central banks are attempting to hold down the value of their currencies instead of letting them appreciate.

Another currency that may be a good alternative is the Indian rupee (INR). While the Singapore dollar is one of the best performers versus the US dollar this year, the Indian rupee has moved lower, and now looks like a bit of a bargain. India’s economy continues to post growth figures that are China-like. Industrial output grew 3.7% YOY in January after a revised 2.5% increase in December. This growth surprised most analysts, who had predicted 2.9% January growth. The higher growth rate should give the central bank a bit more room to raise rates to fight inflation. India’s central bank has raised rates seven times over the past 12 months, and could raise them an eighth time at their meeting this Thursday. Good growth and rising interest rates usually equate to a stronger currency, and the Indian rupee looks like a value right now.

Brazil’s central bank is attempting to fight the markets as investors continue to be attracted to the highest inflation adjusted interest rates in the G-20. Brazil’s government is said to be considering new measures to try and stem the gains in their currency (BRL). Earlier this year Brazil increased a tax on foreign investment in the fixed income markets, and is said to now be considering setting time requirements for foreigners’ stock investments to stay in the country. They have also suggested establishing reserve requirements for foreigners who purchase the Brazilian currency, much like what Thailand did a few years back. These actions, along with threats of further intervention, have held the real down. After moving up over 38% versus the US dollar over the past two years, the Brazilian real has been flat versus the US dollar this year.

Commodity inflation will keep up the pressure on Brazil’s central bank, which will likely have to raise interest rates again in the coming months. As I stated earlier, good growth rates and rising interest rates typically equate to a stronger currency. Brazil’s central bank may be successful in holding down the value of the real in the short run, but central bank intervention is never successful in the longer term.

The euro (EUR) was up a bit versus the US dollar as EU leaders emerged from their meeting with an agreement on a new and improved bailout plan for the region’s most indebted nations. European leaders agreed to widen the scope of the rescue fund and cut the costs of loans to Greece. Ireland wanted cuts to their borrowing costs also, but none were granted. Irish Prime Minister Enda Kenny got into a bit of a spat with French President Nicolas Sarkozy and German Chancellor Angel Merkel over corporate tax rates. Merkel and Sarkozy want to standardize corporate tax rates across Europe, but Kenny pushed back crediting Ireland’s lower corporate tax rate with attracting companies such as Google and Pfizer to Ireland. Kenny’s refusal to agree to higher corporate taxes probably sunk any hope of Ireland getting any reduction in their EU borrowing costs.

From what I have read, the EU agreement is really not much of a change. Officials broadened the size and scope of the bailout fund but refused to buy bonds in the open market or finance buybacks. The onus was placed squarely on the governments who have sought aide, with Greece being the only one getting additional help. The refusal of the EU to buy bonds in the open market was not good news for the ECB, which continues to try and keep rates down by purchasing debt in the open markets.

A separate report released Friday showed that German inflation accelerated to the fastest pace in more than two years on surging energy prices. Inflation in February increased to 2.2% from a 2% rate during the first month of the year. That is the highest rate since October of 2008. All reports indicate that Germany, Europe’s largest economy, is getting stronger. Higher inflation, booming exports, and falling unemployment will likely force the ECB into an interest rate increase as early as next month.

Turning to the US, the data released Friday suggested that the US economic recovery is still on a slow and steady track. US retail sales increased in February by the most in four months, rising 1% and matching the median forecast. Another report showed that business inventories are increasing at a slightly faster rate than expected. But the U of Michigan Confidence index dropped for March, probably due to the rising gasoline prices. Today we do not have any data releases, but tomorrow we will see additional data on manufacturing with the release of the Empire Manufacturing index. Tuesday is going to be a big day for data with the additional releases of the TIC flows, Import price index, and the FOMC rate decision. Wednesday we will get a closer look at inflation with the release of the PPI for February along with some housing data and the current account balance for the fourth quarter of 2010. Thursday is St. Patrick’s Day, and a big day for data here in the US. We will see the CPI numbers for February along with the weekly jobs data, Industrial Production and Capacity Utilization, and finally the leading indicators.

Big week for data here in the US, but the markets will likely stay focused on what is happening in Japan.

To recap… The Japanese yen continues to rise, but for how long? I, for one, don’t think we will see a repeat of 1995… India’s growth continues to surprise on the upside… Brazil is also growing, but the central bank continues to try and hold down appreciation in the real… EU leaders emerged with an agreement, but no real change… Inflation and growth in Germany may force the ECB to raise rates as early as next month, and it will be a busy week for data releases here in the US.

Chris Gaffney
for The Daily Reckoning

Chris Gaffney is vice president of EverBank World Markets and the alternate author of the popular Daily Pfenning newsletter. Mr. Gaffney has been involved in the global marketplace since 1987, and is director of sales for EverBank World Markets. The Daily Pfennig is delivered via e-mail to tens of thousands of market watchers globally, providing commentary that allows them to stay on top of economic, currency, and market happenings. He is a Chartered Financial Analyst and holds degrees in accounting and finance from Washington University in St. Louis.

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