Too Much of a Good Thing

Kuroda implied

Too much of a good thing might

Not be very good


The best (?) thing about keeping up on the global markets is that you learn so many new things all the time. For example, how many of you have ever heard of the ‘Reversal Theory’? If you haven’t been paying close attention to the arcana of central banking, then my guess is you haven’t.

Here is what BOJ Governor Kuroda had to say recently, “Another issue that has recently gained attention with regard to the impact on the functioning of financial intermediation is the “reversal rate.” This refers to the possibility that if the central bank lowers interest rates too far, the banking sector’s capital constraint tightens through the decline in net interest margins, impairing financial institutions’ intermediation function, so that the effect of the monetary easing on the economy reverses and becomes contractionary.”

This ‘theory’ sounds a great deal like the wisdom of the masses with regard to zero and negative interest rates, to wit, if the returns I earn on my savings are zero, then I need to save more money to achieve my retirement goals, therefore I will spend less money now. For banks replace ‘spend’ with ‘lend’. In fact, this is exactly the behavior that we have seen around the world since the initiation of ZIRP and NIRP, especially in those nations with the highest savings rates like Germany and the Netherlands. And yet it has been one of the ‘mysteries’ to central bankers who don’t seem to understand why with rates at zero, people don’t simply spend more money boosting economic activity! The fact that governor Kuroda needed to concoct a theory to explain simple rational behavior is ample proof of just how out of touch the central banking community is with the way the rest of us live.

But there is a larger point to this idea, and that is that the BOJ is publicly warning that QEternity, which has defined their policy stance for the past eight years, may actually be coming to an end at some point. This is not to say it is going to happen this month, but economists estimates are now pointing to a raising of the target for 10-year JGB yields from the current 0.0% to 0.25% sometime next spring or summer as well as a reduction in asset purchases to just ¥40 trillion next year down from this year’s ¥60 trillion. And while that will still represent extraordinarily easy monetary policy, it will be tighter than the current situation. So despite the fact that inflation in Japan remains pegged at 1.0% or below, and has shown no signs of moving up toward their 2.0% target, it seems that the BOJ is preparing the ground for tighter policy. The Fed is already actively tightening; the BOE and BOC have both recently raised rates as well, although are currently on hold; the ECB has already described its path toward tighter policy which is to begin in January; and now the BOJ is moving in that direction. The message I take from this activity is that after nearly a decade of free money, which has led to generally anemic GDP growth alongside virtually no inflation but excessive rallies in asset prices, the central banking community has figured out that they need to try something else. If we see a concerted tightening effort by all the major central banks, even at an extremely slow pace, then I assure you that asset prices are going to suffer. The question is not ‘if’ it will happen but ‘when’ it will happen.

This matters for the FX markets because anything that results in significant asset price adjustments (a euphemism of sharp declines in the stock markets around the world) is going to change the risk profile of the market. And the outcome will be ‘risk-off’ in spades. If you recall how far and fast the dollar rallied during the financial crisis in 2008 and 2009, I would estimate you can look for similar type of price action. I am not saying this is going to happen right away, but my experience has been that it will happen much more quickly than most investors or traders expect. It is for this reason that I remain a strong advocate of maintaining hedge ratios, if not increasing them. I assure you that when things start to get out of hand, there will be no opportunity to address risks then!

With that discussion of the future behind us, a look at the overnight activity shows a very desultory market. Arguably, the dollar is a bit stronger this morning, albeit not excessively so. In the G10, the weakest currency has been NOK (-0.5%), which looks to be following the price of oil lower. WTI has fallen 2.3% since Friday’s closing levels as the mooted extension of the OPEC production cuts have been called into question by Russia’s lack of agreement. As such, it should be no surprise to see the krone fall. But the rest of the G10 space is trading +/- 0.25% of yesterday’s closing levels and so hardly telling much of a story. Interestingly, yesterday after early weakness, the dollar did rebound slightly and this morning’s prices are merely adding to that trend. The point is there is no strong conviction currently about the next significant move in the dollar.

In EMG space, TRY continues to vie with ZAR as the least desirable currency, and today is winning the race by falling 0.6%. It seems that a Turkish banker is going on trial this morning for helping Iran evade economic sanctions. I guess the concern is that if found guilty, the US may impose further sanctions on Turkey and negatively impact the economy and lira by extension. But away from that, this bloc has not shown much life to it, with the daily fluctuations well within the ordinary course of trading.

On the data front, arguably the most interesting numbers are CaseShiller Home Prices (exp 6.04%) and Consumer Confidence (124.0), but I am hard pressed to believe either will change views. More importantly, Jerome Powell will be testifying to the Senate in his confirmation hearings for Fed Chair. Based on the statement he released last night, it doesn’t appear that he is planning significant changes at the Fed in the near term, but it is possible that some Senator could ask an interesting question. In the end, I don’t anticipate any issues for his confirmation on either side, and expect very little in the way of new news from this. So once again, it is shaping up as a pretty uninspiring day in the FX markets, and that’s not necessarily a bad thing. Quiet markets are the best time to update hedges. Don’t miss out!


Good luck




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