Late Friday the Treasury Department released its semi-annual report on global exchange rates or as I like to call it, the semi-annual report on why all other countries on planet earth should let their currencies rise against the UD Dollar. Or maybe the semi-annual report on how easy monetary policy by other countries’ central banks is bad but it isn’t when the Fed does it. Or maybe the semi-annual report on the color of pots and kettles. The Treasury report warned Japan that “(w)e will continue to press Japan…to refrain from competitive devaluation and targeting its exchange rate for competitive purposes”. Japan’s response was that a weak Yen is merely a by-product of their monetary stimulus, language that Ben Bernanke should be familiar with since he has used almost exactly the same explanation about the effects of QE on the US Dollar.
The Treasury report also singled out China, as usual, for holding down the value of the Yuan versus the Dollar and also South Korea for some reason. While the Treasury report stopped short of calling any of these countries official currency manipulators the message to markets was quite clear – the new Treasury Secretary, Jack Lew, just like all his predecessors back to Bush’s first term, wants a cheaper dollar. While we have certainly had other bad economic policies in that time – a lot of them in fact – I can’t think of any policy that has wreaked more havoc globally than the weak dollar. It is the weak dollar that was at the root of the housing and commodity bubbles (which seems to be deflating anew) and the credit boom in emerging markets.
The recent dramatic change in Japanese monetary policy is already having an effect on global capital markets. With their government intent on devaluing the Yen – despite the BOJ’s protestations to the contrary – Japanese investors are searching for less threatening markets around the globe. From US REITs to Brazilian and Turkish bonds, the tsunami of cash coming out of Japan is moving markets. The Brazilian Real has recently started to rise again and it surely isn’t because of that country’s robust growth. The Brazilian economy grew less than 1% in 2012 and recent readings haven’t shown any improvement. On the other hand, 7% interest rates must look mighty enticing to a Japanese saver staring at sub 1% rates and a falling Yen. Even US stocks at all time highs and sporting dividends of 3% probably seem a better bet than staying home and watching the Yen slide.
The problem with all this currency volatility is that it is impossible to know how a country’s citizens will attempt to protect themselves from debasement. Japanese investors might buy Japanese stocks or they might buy Brazilian bonds or they might buy US REITs or Turkish bonds. There is no way to know what will capture their fancy but we know from history that they will act to protect their purchasing power. So, actions by the Bank of Japan can have effects far from Japan’s shores. Capital inflows to Brazil raise the value of the Real and that affects how the Brazilian central bank conducts policy. With an inflation rate of over 6% Brazil is contemplating raising interest rates but doing so now might just cause more capital inflows and a further rise in the Real which will affect their terms of trade. They could offset the rise in the Real by meeting the demand but that would probably make their inflation problem worse. And so, monetary policy made in Tokyo affects an economy half way around the world.
This is not an environment conducive to making long term investment decisions. We don’t know how other countries will react to what the Fed or the BOJ does. We don’t know how investors and businesses will react to changes in capital flows and exchange rates. Will China let the Yuan rise further from all time highs against the dollar? Will Brazil risk raising interest rates? Will South Korea just accept a rise in the Won versus the Yen? What we do know is that monetary policy in the US and Japan, where the largest QE projects are underway, is distorting prices well beyond the borders of either country. And it is when prices get distorted by monetary and exchange rate policies that big mistakes are made. This is stuff of which bubbles and crashes are made.
And what of gold? We had a mini crash in the most precious of metals last week, triggered by who knows what. With all the money printing going on around the world, one would think that gold could find a bid but with US stocks screaming higher on a QE tailwind, the allure of the barbarous relic appears to be fading. The general commodity indexes are also getting crushed as the US dollar creeps higher – despite the wishes of the Treasury Department – and US economic statistics turn softer. With a rising dollar, weak growth and falling commodity prices, the bond market is getting the bid that escapes the gold market.
The US data last week was generally weaker with the retail sales report Friday the biggest downer. Small business optimism fell again with labor market indicators, inventory investment and sales expectations all falling. Taxes and regulations were cited as their biggest concerns with Obamacare taking center stage. The inventory reports both showed a draw although sales at the wholesale level were up enough to reduce the inventory to sales ratio. Jobless claims fell back to the mid 300s but have been swinging wildly the last few weeks giving us exactly zero insight into the state of the labor market. As for the retail sales report, you can read Jeff Snider’s take on it here, but I warn you in advance, it isn’t a pretty picture. My guess is that the higher payroll taxes are finally having an impact but colder than normal weather might have had an impact as well. No matter the cause, suffice it to say the drop in retail jobs in last week’s employment report makes a little more sense now.
Stocks, of course, ignored all the bad news and made another new high. As Doug Terry points out in his tactical update the range of outcomes for the equity markets are very divergent at this point. With valuations at levels associated with very poor future returns, extreme uncertainty regarding the US economic outlook and unprecedented monetary policy actions, we see risk is highly elevated. With stocks continuing to march higher I know that seems strange but it is at just such times of low volatility that risk is most elevated. I don’t know what will come of the Treasury Department’s warning to Japan and all the other pots to our kettle – maybe nothing – but we are in uncharted territory with regard to global monetary policy and I fear – yes, fear – the outcome will not be to the benefit of the global economy or markets. This is not a time to be brave when it comes to investing precious capital.
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