On the virtuous circle of exporting deflation
We thought the following from TD Securities' Richard Gilhooly on Tuesday was a rather insightful way of looking at the whole BoJ effect (our emphasis):
While it remains a contentious point and as yet unproven, Japan's devaluation and soaring Nikkei vs slumping DAX or Bovespa has all the hallmarks of a competitive devaluation. While competing factions debate the Monetary expansion/QQE, versus beggar-thy-neighbour interpretation, one positive aspect of the Japanese Yen collapse and fear of exported deflation has been collapsing commodity prices with weak growth in export countries (China, Germany, S Korea) and a stronger USD helping a supply story (crude inventories at 22yr highs) and weak demand send commodities into a bear market.
The silver lining is that the collapse in inflation expectations may actually provide Germany/ECB with a motive to print to fight deflation and maybe even allow the Fed to print more and expand QE, versus expectations of tapering just 2 weeks ago with the minutes. The equity markets are again high on the sniff of QE adrenalin ahead of the FOMC and ECB next week, and the BOJ this Friday.
While the circularity of this argument is enough to make one's head spin, it appears for now to be a virtuous circle with rising equity prices emanating from slumping commodities. We argued last week that the drop in Gold prices was not bad for stocks and that the relationship is inverse and showed the inverse correlation since last November, falling Gold, surging stocks.
Volatility, we argued was the only reason for the short term positive correlation that lasted but 4 days. TIPs have seen a partial retracement of around 10bpp in b/es after a 30-40bp drop and more QE would appear to be a function of inflation (falling) rather than jobs (tapering) as long as the U/E rate is well over 6.5% and maybe even below if inflation remains 'dangerously' low.
Not that it is really dangerous, as displayed by the equity markets, but that the Central Bank-speak that allowed QE2 in 2010 to address that perilous risk. The upshot to all this is that stocks can't go down and probably go much higher (AAPL after hours) while $/Yen has quickly rebounded and probably breaks 100 this time, leaving bonds nowhere to go but down as today's reversal would indicate. Should a deflationary spiral materialise, which would only come after policies are deemed ineffective or inflation keeps falling to levels that are dangerous, then bonds might rally strongly, but this could only happen with cash flowing OUT of equities. Tomorrow's 5yr note auction is a good opportunity to buy 5s against bonds and a close over 220.5bp on 5-30s would strongly support this view.
The logic of the above is beautifully simple. Not that it's not been said before, but this really gets to the point we feel.
There is a stealth war on to export deflation, ideally in a way that simultaneously imports or steals inflation from elsewhere.
In some ways, it was the US which began the whole thing by inadvertently importing deflation from China over the 90s and naughties and without even realising it. And in so doing, it spread its growth effect to China.
Japan meanwhile has been trying to export its deflation for decades, with varying success. It is in some ways the original Patient Zero. The deflation it managed to export, however, has now created something of a zero sum game because it has led to other countries being forced to repel deflation in similar ways.
Consequently, we have left behind the world in which one man's deflation is another man's inflation. There is very little naturally occurring growth (the sort with good inflation) in the developed world left to capture.
There is of course a lot still left in the emerging market — but that unfortunately still has risk.
Before that risk is reduced the developed world has to reach such a point of wealth parity, that a united endeavour to spread wealth to the still risky areas of the world finally begins to make sense. That is, you get to the proverbial "nothing to lose" stage.
In the meantime, we continue the process of competitive devaluations and stimuli, which while being openly criticised by those with savings to be diluted, are more akin to a virtuous circle due to the wealth distribution effect they bring with it. This is because such easing efforts ensure the deflationary shock is diluted one country at a time, and that hoarded demand stubbornly held back elsewhere is tempted out, until something of a happy parity is reached amongst all. This is indeed something that's equivalent to a global stock dilution effect.
(In some ways, that was what Soros' idea to expand the global SDR allocation back in 2009 was all about.)
But as with all competitive devaluations/stimuli/deflation exports it now all depends on how the next most affected party responds. In the latest BoJ round it's clear that party is Germany, Japan's most obvious and natural competitor. Japan's current gain is understandably Germany's loss.
The question is will Germany overcome its totally unjustified inflation paranoia and act to counter the disadvantage?
If it doesn't the virtuous circle stands to collapse with Germany. In the first instance, that might not be a bad thing for Europe, because a German weakness only makes the periphery look more competitive and strong.
Everything after all is relative.
That said, we're not quite sure how good it would be for Europe in the long term, because even the periphery can't compete internationally if the euro is too strong.
Related links:
Japan 2.0 (and that's a target, mind) - FT Alphaville
In defence of sterling – FT Alphaville
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